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Greek Bondholders at a Loss

Michael Finger
Euro Pacific Capital
October 28, 2011

In an agreement announced overnight, the European Union offered $100 billion to stem an imminent Greek debt default in exchange for a 50% haircut to Greek bondholders. This is a bittersweet victory for those of us who believe in the power of the free market.

When the US government undertook its largest round of bailouts in 2008, it bought nearly worthless assets at 100¢ on the dollar. At the very least, European authorities have recognized that taxpayers shouldn’t be responsible for shouldering the entire burden of bondholders’ investments. However, Brussels is still committed to making taxpayers bear some of the losses – and this is still fraught with moral hazard.

In the absence of continued EU bailouts, Greece would have been shut out of international credit markets years ago. The purpose of European “assistance” has been to keep the Greek debt market liquid enough for Greece to continue borrowing a little bit longer. In theory, this was supposed to buy the Greek authorities time to get their house in order – but in actuality, it has removed the very incentives necessary to make them reform.

Take Ireland as a counterpoint: they’re undergoing a true, painful, and arduous austerity program, and as a reward, they still have to pay back their bondholders at par and are receiving only a fraction of the EFSF bailout funds that are being offered to Greece. It’s no wonder that, in the wake of today’s news, Ireland has called for another round of EU subsidies and permission to impose haircuts on its bondholders.

German Chancellor Merkel stated that the goal of the latest accord is to help Greece achieve a debt-to-GDP ratio of 120% by 2020. In essence, they’re trying to take the patient from death’s door back to a coma. Does this really solve the problem? Who is going to lend to Greece now, in the wake of a 50% haircut and with a target debt-to-GDP that would make most countries blush? None of the underlying spending problems have been resolved by this deal, and Greece is still by any measure a basket-case.

Of course, the euro is rallying on this news, with investors grateful that some discipline was imposed and a total Greek collapse was put off to another day. But this can’t possibly be celebrated as a successful solution. Italy’s debt-to-GDP is not far behind Greece, at 119%. If the same solution were to be offered when Italy faces default, the EU itself estimates that the required bailout would have to be 28 times larger than what is being offered to Greece today. While Northern European taxpayers may be bearing the brunt of today’s $100 billion bailout, they can ill afford $2.8 trillion. Instead, the responsibility would fall on the ECB to print the funds, and thereby devalue the euro.

Fortunately for Europe, the US is well ahead of them on the quantitative easing front. That is why some of the euro rally we’re seeing may be deserved. The euro has taken a pounding relative to the US dollar because of the prevailing sentiment that its problems are worse than America’s; however, no one would ever expect the US government to allow state and municipal creditors to pay 50¢ on the dollar. No, the US government’s position has been that it will be the lender of last resort to all large market actors, and it will make them whole. The US has already bled its taxpayers dry and resorted to furious money-printing to forestall a Treasury rate spike. Europe’s fractured political landscape is actually providing a check on its profligacy that the politically consolidated United States doesn’t have.

Still, it should be clear to all observers now that the Keynesian prescription has not worked, and therefore both continental federations are facing a grim future. It may be that this Greek settlement marks the dawn of a new era of sovereign collapse. Today, for the first time since World War II, a first-world country has outright defaulted on its general debt. Mainstream analysts had said that a day like this would never come. And yet, here we are.

In a best case scenario, Western governments increasingly accept that creative destruction is a part of capitalism – that bad debts must be liquidated fully, honestly, and quickly to make room for new growth. In the more likely scenario, the EU’s structural divide keeps it walking a middle road between bailouts and default of its weaker members, while the US refuses to accept reality until it risks becoming the largest sovereign collapse in history. Let’s hope laissez-faire prevails, but invest like we know better.

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