The Greece crisis

Can someone explain in simple terms why an insolvency crisis in one, not very important European country threatens the economy of the entire continent, and therefore the entire continent plus the U.S. has to bail out that country?

UPDATE: Several replies are posted below. Thanks to those who wrote in.

James R. writes:

Supposebly (with a “b”) because if Greece isn’t bailed out the other PIIGS will want to be bailed out, but if Greece is bailed out then everyone will begin behaving with more fiscal responsibility. Or something like that.

Real answer (rationalization, whatever): It’s to reassure the bond-and-currency markets that the Eurozone will make good on its promises, so there isn’t a run on the other PIIGS, a collapse of the Euro, riots and looting in all the major capitals of Europe, &tc.

Surely now that Greece is bailed out everyone else will behave with fiscal sobriety. (<—a bit of a tone of sarcasm.)

D. in Seattle writes:

In very simple terms, and based on my limited understanding, what makes the Greek crisis relevant to the whole continent is the exposure of European banks to Greek debt. I do not know if this exposure is recent or if it has been built up over the years. Supposedly if the ECB and the rest of Europe were willing to let Greece go bankrupt, or kick it out of the EU, things would be simpler for the rest of Europe economically, but this solution would undermine the EU politically. I don’t know how kicking Greece out of the EU would fix the exposure of European banks to Greek debt, though.

A. Zarkov writes:

“Can someone explain in simple terms why an insolvency crisis in one, not very important European country threatens the economy of the entire continent, and therefore the entire continent plus the U.S. has to bail out that country?”

The one-word answer: contagion. In other words, a Greek default would ripple across the brittle world financial system and cause more and more failures. In particular, the other PIGS (Portugal, Italy, Greece, Spain) would also go into default. How seriously should be take this excuse to bail out yet another debt-ravaged welfare state trying to live beyond its means? I try to answer that question, but the answer is not simple and the reader should consult the links.

It does appear that the world’s financial system is brittle in the sense that its inter-connectedness together with high risk investment polices has created a house of cards set to topple over. While I’m not normally a fan of Nassim Taleb (author of The Black Swan), I recommend listening to this interview with Russ Roberts on his EconTalk podcast. Taleb says that the system is so fragile that a low probability event, such as the simultaneous failure of several large banking institutions, can have large consequence—a world-wide financial collapse. Moreover, we have no way of estimating small probabilities because by definition, these events are rare. As such, the risk analysis that investment banks carry out (as mandated by law) are invalid. I think he’s right about this, and a lot of people believe it now, so governments don’t want to see what would happen if Greece went bankrupt. That’s a part of the technical aspect. The political aspect now follows.

Paul Belien over the the Brussels Journal discusses the political and cultural aspects of the Greek financial crisis here and here. In addition, the immigrant owner-cook at a Greek restaurant near me also provided some insights as to what’s happening in Greece. According to him, the Greeks don’t work very hard. They typically put in four-hour work days, and enjoy long vacations, early retirements, and state-provided life-long security. Nice deal. Paul Belien says the people in the PIGS countries have a different relation with their governments than you find in northern Europe. They know their governments are entirely corrupt (think Berlusconi) and they don’t care as long as the government leaves them alone and keeps the goodies flowing. This means lax tax enforcement, with the implication that we can’t trust official statistics, meaning no one knows for sure just how bad things are, and how much worse they will get.

If one keeps abreast of the unfolding Greek crisis, he will see that the Greek financial hot potato is getting passed to Germany. The PIGS along with France and the other EU countries are in no position to bail anyone out as they are ready to go down the rat hole of debt themselves. In effect, the Germans are getting asked to work harder so the PIGS can enjoy a leisurely life style with good weather. Needless to say, the Germans are not very happy about this, but Angela Merkel, and the Bundestag are telling the German people “tough,” you just have to live with it. Yet another example of how the Europeans have lost control of their governments.

The Greek bailout amounts to $145 billion, which is a lot for a country of only 10.7 million people. Since only five million people (officially) work in Greece, the bailout package comes to $29,000 per worker. According to my Greek cook, that’s money that will never get repaid because the Greeks will never change their life style. They will run short again and in my opinion they will just get another bailout. Americans too have a stake in Greece. We belong to the IMF which is “lending” (really giving) $39 billion to Greece. As explained in this Wall Street Journal article, the U.S. share is hard to determine, and the article gives no figure, but I estimate something like $8 billion (20 percent of $39 billion). Call your Congressman and object, and watch him ignore you.

Finally one can take almost any article on the Greek crisis and substitute “California” for “Greece,” and it will remain approximately accurate. In this case we will have an insolvent federal government bailing out an insolvent state, meaning the U.S. Federal Reserve will print money for California. Ultimately the European Central Bank will have to do likewise for Europe. Already some are calling the Greek bailout a flop. The only way for the U.S. and Europe to cope with their debt crisis is to confiscate, through inflation, the savings of the people who chose to live within their means. Such is liberalism. It destroys everything.

A. Zarkov writes:

A few minutes after I predicted that the European Central Bank (ECB) would ultimately print money to bail out the EU, I came across this press release from the ECB:

In view of the current exceptional circumstances prevailing in the market, the Governing Council decided:

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.

I’m not exactly sure what that means, but I think it means they will print money. Of course “print” does not literally mean put ink on paper to make currency. It means expand the money supply using the ECB magic checkbook. With the magic checkbook the ECB can just create money by typing on a computer terminal. It’s worse than printing, at least printing has physical limit.

Then I also got a press release from the U.S. Federal Reserve.

The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank. The arrangements with the Bank of England, the ECB, and the Swiss National Bank will provide these central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed rates for full allotment, similar to arrangements that had been in place previously. The arrangement with the Bank of Canada would support drawings of up to $30 billion, as was the case previously.

Again we have to decode the message, but it means expand the money supply. They assume they can reduce it later. That’s why they say “temporary.”

Let’s remember central banks can only fix a “liquidity” crisis when a bank gets into a cash flow problem. A central bank cannot cure insolvency. Insolvency means someone loses real wealth. It’s the central bank’s job to make sure the loss is passed onto you and me.

Prakhar G. writes:

I am by no means an expert on this topic and furthermore, this is a very complex topic that cannot be explained in just a few lines. Nonetheless, here is what I have managed to gather:

1) Several European banks have invested in Greek bonds for the simple reason that under current international accounting rules, sovereign debt is treated very favorably. A default from Greece looks very bad for their balance sheets.

2) In a (very) extreme case, a sovereign debt-crisis could force Greece out of the single-currency zone either from internal or external pressure. This is unlikely but if this happens, it would be catastrophic for the Euro.

3) Greece is the first in a long line with Spain, Portugal, and Ireland next. If one sovereign can default on their debt, so can others. After all, no private institution could ever get away with the kind of balance sheets that nearly every government has.

4) If no other options open up, the ECB may have to adopt inflationary measures like buying sovereign debt which would be terrible for the Euro.

5) The Euro like the U.S. Dollar is a fiat currency and its value is contingent on its managers (European governments) acting like sane adults. If one of them defaults, what does this say about the reliability of the rest and of the Euro as a whole?

Hope that helps. the FT has more information. As do other news sources.

Mark P. writes:

To answer your question briefly, the rest of the EU countries, especially the biggest ones like Germany and France, made massive investments in Greece. These investments were, effectively, bribes to prevent Greece from leaving once the “sticker shock” of shifting to the Euro was realized. Without these “investments,” the Greeks would never have tolerated the huge price increases they experienced when they converted from the Drachma to the Euro.

To understand the underlying problem, one has to realize that the “Euro” is actually the Deustchmark. The process of shifting to the Euro meant that every single EU country’s currency defaults to the value of continetal Europe’s most valuable currency, which was the Deutschmark. This occurs because companies end up selling their products where they can fetch the highest price, which means selling the bulk of their output to German consumers. Therefore, a Greek citizen ends up paying as much for his locally produced feta cheese and olive oil as his German neighbors to the north … only problem is the Greek has probably less than half the income of the German.

To get around this problem, the EU made massive investments to increase the income of the Greeks, effectively lending them the money they needed to live like German consumers. Of course, the Greeks are not as productive as the Germans and they are not likely to move to Germany. Thus, the current crisis.

When the EU had separate currencies, the PIIGS were able to adjust economically by having currencies that were cheap relative to the Deutschmark. So, German consumers got a good deal buying Greek exports because the Drachma was always trading at a discount to the DM, or declining in relation to the DM. This, of course, made German exports to Greece very expensive, but, locally produced products were always affordable for Greek citizens.

Under the Euro, however, not only to German products remain as expensive as ever, but all locally-produced Greek products are now as expensive as if they were being made in Germany and sold to Germans.

To put it another way, it’s why BMWs cost the same in New York as they do in North Dakota, even though North Dakota has poorer citizens.

Personally, if Greece was smart, it should junk the Euro, go back to the Drachma, and open up free-trade agreements with China and India. They would become the Port of Europe and Greece would have another Golden Age. But they won’t do that.

Edward writes:

Everything your contributors write is correct but inadequate. The lethal danger is not the PIIGS but the fact that only a few years from now the English will be in line to default. By the next decade the final domino to fall will be the USA. The Greek annual budget deficit is 14 percent of the GDP. the American annual budget deficit is 10 percent of GDP and expanding. It is estimated that when interest rates rise to six percent it will consume 80 percent of all income tax revenue to service the American debt. This is unsustainable and will in about 10 to 12 years lead to a financial panic in America and the Western world. That is why I have from time to time been sending you articles about economics and the financial situation in the United States.

It is not only demographics which place us in peril but also our economic situation and our failure to address the coming shortage of natural resources.

Prakhar Goel writes:

Boy things are changing quickly. Looks like option 4 on my list has been taken:

WSJ: “The European Central Bank, in a stunning change of position, said Sunday night it will buy government and private debt on “dysfunctional” European markets … “

More info here.

Posted by Lawrence Auster at May 09, 2010 11:52 PM | Send