The debate about whether Greece can survive in the euro gets more and more surreal. The leaders of the European Union and the European Central Bank (ECB) are still insisting that a Greek default on its debts is impossible.
But a glance at the price of Greek debt, and the cost of insuring it against default, tells you Greece isn’t going to be paying back the money it owes – not in full, anyway. Bland, myopic assurance from European finance ministers will only make things worse. It’s time they stopped burying their heads in the sand and started figuring out how to cope with Greece going bust.
The degree to which central bankers and politicians are still in denial is neatly illustrated by the fiasco of the ‘stress tests’ that are currently being carried out on Europe’s major banks. It was not, in principle, a bad idea. The markets have been speculating feverishly for months over the possibility of huge losses on dealings in Greek, Spanish or Portuguese government debt lurking somewhere within the banking system. The tests will probe the soundness of each bank, look at how it might stand up to different shocks, decide whether it has enough capital to pull through, and recommend if it needs to find some more cash from somewhere. That, surely, will reassure the markets?
Well, probably not. Because the possibility of a Greek default won’t be among the scenarios under consideration. According to José Manuel González-Páramo, the Spanish board member on the ECB, the regulators don’t need to test the scenario of a sovereign default by one of the euro-zone countries. The idea is “absurd”, apparently. “The euro cannot allow a default and therefore it’s nonsense doing a stress test based on that,” González-Páramo said last weekend. But that is, to use his own phrase, absurd. The possibility of a default is the one thing that the markets are really worried about. It’s a bit like BP saying it has run though all the possible future scenarios it might face, and costed them fully – but it has ignored the absurd possibility that it won’t be able to cap the oil currently spilling out of its well in the Gulf of Mexico.
A Greek default is precisely what the EU should be worrying about. Greek government bonds currently yield 10.2%. That is more than four times the 2.5% yield on German government debt. If both Greek and German government bonds are rock-solid investments, on which there is zero possibility of default, how come the German bond is four times as valuable as the Greek one? Simple. You’ll almost certainly get your money back if you buy the German bond, but if you buy the Greek one you probably won’t. A survey released this week by CMA DataVision concluded that Greek debt was now the second riskiest in the world. Venezuela was still a worse bet. But Iceland, Egypt and Romania, those paragons of fiscal rectitude, had all pulled ahead.
It’s nonsense to pretend that there can’t be a default by a euro nation. Greece is stuck in a deflationary trap, from which it’s unlikely to escape unless it restructures its debts, or devalues its currency, or quite possibly both. Even if the austerity programme for Greece works, and there isn’t much sign that it will, Greek debt will still rise to 139% of GDP by next year, according to calculations by the Bank for International Settlements.
Greece’s debt burden just keeps growing, the capital markets remain closed to the country, and sooner or later the interest payments are going to become unsustainable. Yet the EU and the ECB are sticking to the line that Greece will be just fine, and the euro will look in great shape once the markets calm down. Instead, they should be planning for an orderly, managed default by the Greeks, and possibly the Spanish and Portuguese too. In truth, a default need not be catastrophic. A decade ago, Russia defaulted on its debts, but came back quickly. Thailand effectively defaulted during the 1997 Asian financial crisis by devaluing its currency sharply. But a decade later the Asian countries, including Thailand, are all growing strongly again.
There are two big problems that need to be addressed if Greece goes bust. First, the European banks have huge exposure to Greek debts, as well as the rest of the highly indebted eurozone countries. Between then, French and German banks have an estimated $1trn in paper issued by Greece, Spain, Portugal and Ireland. If that suddenly has to be written down to nothing, it could trigger a wave of banking collapse right across the continent. Next, the cost of borrowing for Spain and Portugal, and possibly Ireland and Italy as well, could soar as investors start worrying they will be next. If they were locked out of the capital markets, it could make default inevitable.
But both problems can be addressed easily enough. First, make sure there is enough support for the banks. Next, make sure there is money available to fund the Portuguese and Spanish deficits until the markets get back to normal. It is far better to deal with problems early and decisively. Just denying that Greece could ever default is pointless, as it probably will. The sooner the EU owns up to that, and starts planning for the fall-out, the better.