Monday, June 29, 2015

A Greek default does not rise to the level of a systemic risk

Greece is out of money, and its current government and economic policies are not supportive of a lasting solution. All the money it's borrowed has been wasted, flushed down the statist drain, in order to support Greece and its citizens in a style they can't afford. What's happening now is like musical chairs: when the Greek music stops (coming soon), someone (e.g., the EU, ECB and IMF) is going to have to record the loss on their balance sheet. The question is not whether Greece will default, but how it will do it and who will pay the eventual price.

Meanwhile, despite the strong likelihood that Greece will not find a lasting solution in the coming days, financial markets are not displaying any signs of distress. To be sure, there is lots of worry out there, but markets are still quite liquid and functioning normally. This makes sense, because a Greek default is not an earth-shattering event that comes out of the blue. It's been a long time coming, and Greece is a very small cog in the global financial markets.

The chart above shows 2-yr swap spreads in the U.S. and Eurozone. At current levels, swap spreads are well with the zone of normality. As such, they are saying that financial markets are liquid, and systemic risk is low. If a Greek default were a serious threat the stability of the Eurozone financial system and economy, swap spreads would be much higher—like they were when the PIIGS crisis reached a peak in late 2011.

The chart above shows the Vix index, a barometer of the market's level of fear, uncertainty and doubt. It's jumped up from 12 to almost 20 in the past six days, and that's telling us that markets are worried that something might go wrong. But if this were a really serious worry, the Vix would be a lot higher than it is today.

Putting the two together, it's obvious that markets are nervous, but it's comforting that there is virtually no sign that an unpleasant resolution to the Greek crisis presents any threat to financial markets or even the Eurozone economy.

If anything, a painful resolution to the Greek crisis would be a reminder to other countries that unproductive economies with bloated and inefficient governments are unsustainable and ultimately very painful for everyone. The best solution for Greece would be to grow its way out of debt, by reducing the size of its government and adopting pro-growth economic policies.

UPDATE: I refer you to a good post of mine from several years ago: "Greek Myths." It discusses in more detail why a Greek default and/or a Grexit do not spell doom for either Greece or the Eurozone.


indyspiral said...

Do you think that Greece can be both in the Euro and out of the Euro simultaneously? In other words, if they begin paying their government workers IOUs, this is essentially creating an alternate currency. But the people of Greece will prefer Euros over the Greek IOUs. Could both of these two currencies exist side by side? What does it really mean when it is said that Greece will be kicked out of the Euro? After all, some countries use the US Dollar as their currency and how is it possible for the Euro zone to prevent the people of Greece from using Euros as their currency of preference? Does being kicked out of the Euro zone really just mean no longer having the support of the European Central Bank's emergency liquidity fund? Great post, by the way.

Benjamin Cole said...

Seems to me the ECB can easily balance any remaining negative results from Greece.

Greece needs to Grexit and print cheap drachmas and cut government in half.

But structural reforms are nearly impossible in democracies.

Which poloitical party in the USA will eliminate the USDA, raise the Social Security retirement age, or cut veterans pensions and benefits, or cut food stamps?

Scott Grannis said...

indyspiral: Of course Greece can have two currencies. Argentina has done that off and on for many years. The government dould issue IOUs that would be euro-based, perhaps, but which would trade at a substantial discount to euros. The government could fund its deficit by printing IOUs. Those who accept the IOUs at a discount would be effectively paying taxes to the government. Euros could continue to circulate, and everything could be priced in euros, but a lot of income would be received in the form of discounted IOUs, thus impoverishing most of the populace. That is equivalent to what would happen if Greece decided to issue its own currency: to foreigners everything would become cheaper, but Greeks' living standards would decline because all imported goods would become more expensive.

Joseph Constable said...

Greece won't be a problem if Spain and Italy don't become a problem. Today both Spanish and Italian government bonds dropped in price but they did not go below their recent lows.

When something is expected to be bad and it isn't then the door opens for opportunistic buying. I am thinking US stocks, not sovereign bonds.

Benjamin Cole said...

Who lent $70 billion to Puerto Rico? Why?

Were PR bonds rated?


Steve Fulton said...

Since Obamacare passed, the market cap of the 4 largest US health insurers has risen by about $200B, pretty close to what Greece owes. maybe Congress should pass a law that every American must buy a vacation in Greece every year and then Greece would be rolling in dough!!!

Unknown said...

If Greece leaves the Eurozone then a dangerous precedent is sent that leaves the door open for some of the weaker EU economies to do the same thing perhaps during the next EU recession. Under such circumstances having Spain or Italy exit the EU would certainly have significant global economic consequences.

Scott Grannis said...

I'd argue that a Greek exit from the Eurozone would be so painful that the weaker EU economies would be in no rush to suffer the same fate. An exit would almost certainly involve a significant devaluation, which in turn would amount to a huge transfer of wealth from the average guy to the government.

Thinking Hard said...

Benjamin - Good article from the WSJ journal on Puerto Rico the other day. Please see

Scott- I agree that Greece defaulting by itself does not seem to pose much systemic risk. The CDS market places a high probability on a Greek default. I like the comparison to Argentina and that is the likely outcome it seems.

Unknown - The EU will need to make an example out of Greece to deter other faltering nations from going along the same path. The situation within Greece will likely be very ugly to deter the populace within the other PIIGS nations from following the same path.

What is the derivative exposure to Greek debt within the financial sector of the EU?

Frozen in the North said...


I think that you are taking a very American view of a problem that has serious consequences. I mean the VIX is really an American risk view -- the White House said it , there's no real perception of problem here from an Greek exit of the Euro. However, the exit of Greece shows the weakness of the Euro system -- a Federal System with very independent nations (hey what's Porto Rico up to?). Honestly, if ECB/IMF cannot deal with Greece what are the hopes when a "real country gets into trouble". Fundamentally, the Greeks were irresponsible (no doubt) they were surrounded by enablers, but its a small country and should be manageable. Yet its not!

As for the contagion risk, I will tell you that everyone "in power" will say the same thing -- there is no contagion risk, because to say otherwise would be irresponsible -- the whole financial system is built on trust. If the head of the Bank of England was to say -- there is real systemic risk with the exit of Greece, the impact would be dramatic.

There is no doubt that ECB and the banks and the pension holding Greek debt have cleaned up their books, but there is still a lot of Greek debt which is not in the hands of the ECB/IMF, almost 60% of Greek debt is in private hands. Assume a 50% haircut (which I think is low). For there to be no systemic risk you have to assume that these guys didn't buy some CDS protection for their Greek portfolio.

It was announced that JPM and City both have around $70 Trillion in gross derivatives -- how much of that is with parties that may have written some naked Greek debt protection? I'm not worried about the smart guys in the room, I worried about he dumb cretins who's done a stupid deal to "create some income" .

indyspiral said...

Frozen in the North,

There is no remedy for the problem that Greece presents.

If a bank is mismanaged, bailing it out simply transfers the loss from the investors in that bank to the taxpayers.

If a nation within the Euro Zone is mismanaged, bailing it out simply transfers the loss from the people of the mismanaged nation to the relatively better managed countries.

The best policy is to let banks go bankrupt and let countries go bankrupt. There is nothing in the rule book that says that when you purchase a bond from (loan money to) a bank or a country that you will get repaid. The possibility of default must be real in order to force creditors to consider the risks of making these loans.

If it is determined that some bank or some country is too big to fail, people will see reduced risk in loaning money to that bank/country. The result is lower interest rates and a bubble. The European Central Bank should play a hard line. So should the US regarding Puerto Rico.

If you read Peter Wallison's book "Hidden In Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again" you will learn that when the multiple Presidents indicated that creditors to Fannie Mae and Freddie Mae would be bailed out, it gave those corporations interest rates almost as low as US Treasuries. When the Bush Administration's appointees Paulson and Bernanke bailed out Bear Stearns, a non-FDIC insured bank and stated that they had to bail them out due to "interconnectedness," the signal was that larger banks would be also bailed out. The result was that investors did not sell Lehman bonds believing that the US Government would make them whole.

Bailouts are a slippery slope. Best not to get started on them. And if started, stop as soon as possible.

Benjamin Cole said...

If the ECB exits of, say, a Portugal, Spain and Italy are done in an orderly fashion, what are the risks?

As for Greece, they will never flourish as part of the ECB. The ECB is making monetary policy for Germany, not Greece.

Monetary policy must be made with the facts on the ground, not in a utopia as defined by central bankers.

Has tight money ever worked in any modern economy?

indyspiral said...

"Has tight money ever worked in any modern economy?"

I guess it depends on how you define tight money.

The problem that Greece is suffering from is too much government spending and too much government regulation, not tight money. At that's the opinion of this non-expert.

I actually don't see a disadvantage in tight money as long as society expects tight money, if it is not a surprise.

If 50,000 dollars buys you a BMW today and you knew with near certainty that 50,000 dollars would buy you a BMW in the year 2030, you might be willing to loan 50,000 dollars to a credit worthy person or business at a low interest rate. But if you fear inflation, you have to jack up the interest rate.

In our situation, we really don't know what if the BMW will cost 50,000 dollars in 2030 or if it will cost 250,000 dollars. So, long term interest rates must take that into consideration.

So, I tend to think a predictable money supply is the best money supply. Has any nation ever accomplished that?

indyspiral said...

Another thought about Greece.

The European Union should never have given Greece a "bailout."

Instead they should have done two things:

[1] Told every bank in Europe that, if Greece should default or miss a payment on Greek debt, the European Union would pay 80 percent of the missed payment. A "free" credit default swap.

[2] Given Greece an 11 billion euro aid package, not a loan, a gift. 11 billion euros is 1,000 euros per Greek citizen. It could have been a transfer to the government or a transfer directly to citizens.

After doing those two things the EU could just say, "That's all we are going to do. The rest is up to you."

Also, perhaps there should be a structured means of European Nations developing their own parallel currency for situations like this. Let Italy and Spain and Portugal know that if their debt gets too high to handle, they can create a parallel currency. The school teachers might not appreciate being paid in monopoly money instead of valuable euros. But that's the way it goes, right?

Hans said...

This affair has been well time with the World Soccer Tournament.

Since Grease has never had a competitive team, this is a delightful
event to turn the world's attention to it.

The country is not leaving the CM or the Euro because it can not provide
for it's people.

It is easier to extent one's hand and receive gifts from the IMF and the

BTW, this is entirely the product and result of Socialism in action..

Mr Fulton, has perhaps the best solution for this failed state!

William McKibbin said...

All things being equal, a national default by a member of the EU should result in an uptick in commodities, especially precious metals -- however, we now see that precious metals actually declined concomitant with the Greek default -- thus, we have apparent evidence of monetary manipulations to "smooth over" the Greek default's effects on bonds and other equities -- but make no mistake, the global central banking regime has been "rocked" by the Greek default, and no doubt is alert to a domino affect across Spain, Italy, and Portugal -- hopefully, fiscal-policy makers around the world (including US states and municipalities) will learn lessons from Greek default -- looking forward, I'll be interested to find out of a default event is declared triggering credit default obligations along Wall Street -- we are watching a unique monetary and fiscal-policy making failure unfold right before our eyes...

William McKibbin said...

PS: What I observed about Greece and the US back in 2010...