Debt on one side of the ocean is little different from debt on the other. But most investors don’t seem to see it that way. Instead of learning from the tribulations of their cousins in Europe, they greet the news from the Old World with alarming complacency.
This is too bad. Because the European story tells us something important about the way a debt crisis works. And it gives us a “heads up” about what will happen on a much larger scale in America.
Debitum delenda est: Debt must be destroyed. And the process of destroying – defaulting, hair-cutting, writing down, writing off, going bust – is as painful as it is unavoidable.
The millstones of debt may grind slowly…but they are relentless. This week we watched them do their work on Greece. Sometime in the future, we’ll see a sequel to the Greek story. It will be set in America. Greece has never been a reliable or faithful borrower. Instead, it has been a deadbeat – borrowing and then defaulting. It has been in default, in one way or another, during half of its history as an independent, modern nation.
But in the heady days following European unification and the introduction of the single currency, Athens seemed as good a credit risk as any other. Previously, lenders had been wary. They feared the Greeks would default, often by devaluing their currency, the drachma. So, lenders demanded higher interest rates to offset the risk of loss. This, of course, raised the cost of borrowing for the Greeks and generally held their spending in check.
But the Greeks joined the Eurozone. And it looked as though the risk had been removed. Loans to Greece were denominated in euro; lenders no longer feared a devaluation of the currency. Lenders asked little more in yield from Greece than they did from Germany and France. Interest rates were “harmonized.”
A sour note was sounded when Europe’s banks tottered in the credit crisis of 2008. It quickly became obvious that the Greeks were still Greeks. They had borrowed too much. They had spent too much. Now their ability to repay their loans was seriously in doubt. Yields on Greek debt rose. This made it harder for the Greeks to keep servicing old loans as well as adding new debt. And it called into question the solvency of large European banks, which held billions of Greek debt.
This caused the EU, the ECB and the IMF to intervene. If the free market would not lend to the Greeks at a sufferable rate, the authorities would have to do so. The ECB came up with €90 billion for the Bank of Greece. This was bold.
Perhaps foolhardy. The Greek central bank was reported to have had only €815 million in capital – or less than 1% of the amount it borrowed. Naturally, the ECB – led by the Germans – attached conditions. The Greeks were supposed to put their financial house in order so they might have some hope of repaying the loan – or at least not asking for another one.
Athens made a show of it. But try as it might, it couldn’t turn Zorbas into Helmuts. Taxes went uncollected. Workers didn’t show up. And people rioted – attempting to burn down the finance ministry – when their government tried to force austerity measures on them.
This left Greece in breach of the terms of its bailout. It also left the IMF and ECB with a bigger problem. Because now Greece needs more money. It cannot borrow from the free market. So it needs another bailout.
If the rest of Europe had their wits about them they would say to the Greeks what President Ford told New York City when it was in a similar situation in the 1970s: “Drop dead.” The city realized it could not continue borrowing and spending. It had exhausted all other options; it had to do the sensible thing. NYC flourished as a result.
But there is more to the story in Europe. If they tell the Greeks to drop dead, many large European banks – including the ECB itself – will have cardiac arrests too. Athens may have borrowed and spent recklessly and wantonly. But Paris, Berlin and Brussels were foolish to lend to them. And now it is difficult to separate the fool from the knave.
The ECB didn’t just cough up €90 billion for Greece. It also lent €106 billion to the Irish, €44 billion to the Spanish and €48 billion to the Portuguese. If these loans go bad, the ECB will face insolvency.
Fool? Knave? As you can see, the ECB is both. Perhaps it once lent to save the world. Now it lends to save itself.
What will happen when the credit runs out? That’s the trouble with the kick-the-can-down-the-road approach to debt. You end up down the road; and there’s the can! If the borrowers cannot make good on their debts to the ECB, the bank will run out of money and have to issue capital calls to its member national central banks.
The Germans, for example, will get a bill for 27% of the necessary funds. Other central banks will be asked to put in lesser amounts. But many of the member banks are the same as those that desperately need financing from the ECB. They won’t be able to meet the capital call; they’ll be making capital calls of their own. This will probably force Germany and France to shoulder larger percentages of the bank’s financing requirements and may force the weak banks (and the nations they serve) out of the system all together.
European officials have called this outcome “unthinkable.” But it is also an outcome that seems more and more likely. In the meantime, expect a combination of fraud and spin…as the authorities attempt to disguise and delay the inevitable default.
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