Wednesday, February 10, 2010
The Greek Treasury will give away one giant wooden horse or every $1 billion of bailout money. Inside are public sector unionists waiting to spring!
Tomorrow at 4:45 Brussels time the EU will issue a press statement summarizing their deliberations on the pending Greek fiscal crisis. The markets have scraped themselves off the bottom the past few days on the hope that the EU will announce a support package for Greece. The foundational documents of the EU charter and the various legal agreements that created the Euro-zone tie the hands of the ECB and the EU to some extent though it seems as though the various European governments have spent some time looking for loopholes which would allow them to come to the rescue for Greece. There is nothing official as of yet but the market rumour seems to be that some of the stronger EU member states will announce guarantees of Greek debt conditional on the Greeks achieving certain fiscal targets.
This is setting the stage for a great drama. The main issue here is that over the next 12 months Greece has to sell about $75 billion worth of debt or about 20% of GDP. It sounds like a lot but under normal circumstances it wouldn’t be totally outrageous. These, however, are not normal circumstance. Partially on account of the financial crisis and partially on account of the fact that historically the Greeks have been living beyond their means, the fiscal deficit of Greece has grown quite large. One of the reasons that it has grown so large is that it has been relatively easy for various interest groups within Greece to hold the government hostage through strikes for large payouts from the government. So not only does the government have to roll a lot of old debt, it has to issue a lot of new debt as well.
The people who have to buy this debt, the worlds fixed income investors, have recently grown very sceptical about the ability of the Greeks to pay this money back. The Greek debt to GDP ratio is already very high, the budget deficits have been getting worse and the efforts of previous governments to close them. Over the last several weeks the interest rates that investors have demanded from the Greeks to roll their debt have spiked. Having to pay higher interest rates can by itself widen the governments’ fiscal deficit and this can then become a vicious cycle which ends in default. Given that the Greeks are in the Euro-Zone and therefore their money supply is controlled by the ECB rather than their own government they have only one thing they can do and that is to close the fiscal deficit.
And this has set up a three way game of chicken. The Greek government has two objectives, keep Greece afloat and stay in power. To keep Greece afloat they have to cut the fiscal deficit. To stay in power they have to do that without making too many people angry. So far their strategy has been to announce massive increases in taxes and massive cuts in benefits in an attempt to close the deficit. They are counting on fear of the majority of the population of an economic collapse in event of default to outweigh the anger of the people who will be harmed by the cuts.
The public sector unions have it a little easier. Their objective is to maintain their salaries and benefits. Their strategy is to make the government have to choose between remaining solvent and staying in power. To try to undermine the government the public sector unions have called a strike and some of the private sector unions have joined them. In previous attempts to implement austerity measures these strikes have degenerated into riots and brought down the government. This may or may not be a realistic possibility but until today these strikes have been scaring the hell out of investors.
The people with the most difficult hand to play are the other EU governments. Their objective is to maintain the integrity of the Euro system. Ideally Greece would enact the tough reforms necessary and all would be well. As per the above, however, there seems to be anything but consensus within Greece as to what should be done. The first problem they have is that all of them are also elected politicians and taxing your own people in order to help fund the lifestyle of the Greeks is going to go over like a lead balloon. The second problem is that the options you have are somewhat limited on account of the various treaties that govern the EU and the Euro. The kinds of things that the Fed and the Treasury department in the US did last year to save the banking system such as outright purchases of securities by the Central Bank cannot be done.
The most important problem facing the EU however is a game theory problem. If they signal that they are willing to help Greece they will embolden the public sector unions to continue to resist the governments’ austerity measures and in so doing to convince the Greek government that it will be easier to negotiate terms with the EU than with the unions. The follow on would likely be a speculative attack on Spain and Portugal in an attempt to force the EU to come to their rescue as well.
If on the other hand the EU signals a willingness to let Greece default this would certainly encourage those betting against Greece and frighten potential investors who are necessary for Greece to be able to issue the debt to meet its requirements in 2010. This would also likely provoke a speculative attack on Portugal and Spain. In strategic terms it would weaken the Euro Area and the confidence in the weaker member states and potential entrants. This is because if Greece still had its original currency it could just print the money and take the pain in the form of increased inflation. Inflation is just as or more destructive than fiscal austerity but it can be done without leaving too many political fingerprints and is therefore easier to achieve.
As you can see, its quite a narrow needle that the EU needs to thread tomorrow. Here’s what I think will happen. I think that the EU will announce tomorrow a series of steps to support Greece such as loan guarantees or other aid. This assistance will be conditional on Greece enacting reforms so draconian that the aid would in fact not be needed. On hearing this the markets will attack Greek debt in an attempt to force the hand of the EU. My guess is that the EU will stand pat either through will or indecision and eventually the majority of Greeks who support the reforms will prevail over the minority who oppose them and Greece will not default. I predict that after a sharp sell off markets will stabilize as it becomes clear that Greece will enact the necessary reforms. Then they’ll turn higher floating on the global sea of liquidity being produced by our man Bernanke. You heard it here first.