2010 May 4
by Dave

The parallels between the ongoing Greek debt “crisis” and the ongoing Deep Horizon oil leak are interesting. Both were obvious threats thought to be unlikely enough that those ultimately responsible for dealing with them felt no need to actually come up with a plan in advance. The wait for the giant containment dome and the wait for a final plan to deal with Greece’s increased borrowing costs are playing out against backdrops of ever more dire news that never fails to materialize once the public has absorbed the previous round of bad news and decided that the world isn’t going to end.

The big question looming over both of these disasters is two fold. How much damage will it do, and how much will the world as we know it be changed in the aftermath. The answers for the oil spill have well defined boundaries. Either the wetlands along the gulf will be destroyed, allowing massive erosion and a wild life die off, or the bulk of the spill will not make it to shore and only the fisheries will be devastated. Long term changes will range between a complete ban on new drilling coupled with improved safety standards and enforcement to nothing new being done at all.

Sadly, if I were a gambling man I’d have to bet on the doing nothing outcome.

Unfortunately for Greece and the European Union, only the best case scenarios are clear. Krugman’s analysis of the meaning of the size of the Greeks’ structural deficit is pretty convincing. Debt forgiveness alone would still leave the Greek government with no way to fund ongoing budget deficits. Leaving the Euro and devaluing their currency is the only way to mitigate the pain of the necessary changes and keep wide spread social unrest at bay, unless you believe that the Germans are willing to give Greece money rather than lend it on an ongoing basis.

It is really starting to look as if it is not a question of if Greece will leave the Euro, but rather of when. I have a nit to pick with Krugman and many other commentators on their interpretation of what this will mean. They speak of a spread of contagion to other risky Euro area countries. What will actually happen is that the bond markets will recognize that other Euro countries actually could leave the Euro and are not “To pegged to fail.”

Once countries joined the Euro they were able to borrow at the same rate that Germany did. Obviously the markets felt that a Greek or Portuguese default was no more likely than a German default. That is silly. What the markets were really pricing into Euro area debt was an implicit German backing of all Euro denominated government bonds. Kind of dumb given that German law expressly forbids bailing out other Euro area governments.

So once the lack of a backstop and the ability to pull out of the Euro and devalue, or just default and stay in the Euro becomes an explicit reality, the bond markets will have to reprice all Euro denominated government debt to reflect actual risk. Restoring an incorrectly priced market to its true fundamental price point is not what I’d call contagion.

An overcorrection is what I’d call contagion and I wish that the economic and political comentariat, whom are better informed than I, would explore the possible overcorrection more fully. As I see it, the overcorrection will be caused by debt issuers already holding incorrectly valued bonds. They won’t want to sell their bonds, because then they’d have to write down the loss and impair their notional core capital ratios. Any banker sitting on a pile of Euro bonds that they can’t sell or reprice will be loathe to increase their exposure to Euro denominated debt at any price.

The end game is debt markets seizing up and the Euro completely falling apart because Germany won’t let the ECB print money and force a Euro wide devaluation. This slow motion train wreck would keep the dollar too strong and imbalance global capital flows to the point where an actual global depression isn’t unfathomable.

In the meantime the stock markets have been moving in lockstep with the dollar again. The dollar goes up 2% and the Dow goes down 2%. Investors apparently believe that current equities valuations correctly price in the risk of a second, deeper dip. Crazy?

It feels like we are back in the fall of 2008 again but this time every one is afraid to spell out the risks for fear that someone might listen to them. I’d really like one of the grown ups to tell me that I’m just scared of shapes in the dark. While I wait I’ll just have to pull my blanket over my head and hold my stuffed Bernanke Bull tight.

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