Sovereign Debt: A Modern Greek Tragedy - Austerity Measures and the Real Default Threats

May 07, 2012

Ireland and Greece enacted austerity measures that were highly unpopular and generated substantial social unrest, yet the measures generally did what they were supposed to do. Still, the risk of default by these smaller countries raised a red flag to the real threat: a default by Italy or Spain, which have much larger economies and debt outstanding. Italy has €2 trillion in debt and must roll over €300 billion in 2012, an amount greater than the entire Greek debt. The EU and IMF provided a total of more than one trillion Euros in several loan packages since 2010 to ease rollover problems, and the Central European Bank injected €1 trillion of liquidity into the banking system. These actions helped calm the overall situation until March 2012, when Greece effectively defaulted on half of its debt.

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Christopher Waller: Now, austerity. Well, your debt's too high, your deficits are too high, you've got to typically raise taxes, cut spending or maybe inflate it away. Well, when you're in a single currency, you don't have the option to just inflate it away, which has been a time-honored thing that governments have typically done. So you're stuck with austerity to deal with these fiscal things. So both the Greek and the Irish governments enacted very unpopular—as we've seen over the weekend, according to election outcomes—very unpopular austerity measures to remedy fiscal woes. Now, did it have some effect? Yes. Greece's deficit-to-GDP fell from around 16 percent to 9. Ireland's went from 31 down to 10. So these measures did what they were supposed to do.

But in the process of raising taxes, cutting spending, slashing things, you upset people. The issue is do they burn everything down or do they just grumble and go to work? The Irish tend to grumble and go to work, the Greeks tend to get mad and burn stuff down. Now, what was the response? When this crisis first hit in May 2010, the European governments together with the IMF said "we've got to step in and provide some funding for these smaller GIPS." So they provided about 750 billion euros as kind of a fund to finance this with the idea that if we provided this funding, it would calm everybody down and this problem would kind of go away. Now, the biggest contributors to this fund, and this is critical for everything, Germany and France. They're the two biggest countries in the euro. They're the driving force for 40 or 50 years on the creation of the European Union and the economic monetary union. Germany kicked in 120 billion, France kicked in 90 billion.

Now, German banks, why would they do this? Well, German banks were holding Greek debt. They held about 8 percent of the Greek debt—24 billion euros worth—and French banks held about 5 percent, about 15 billion euros. Now, just look at these numbers and look at these numbers. They're putting in a lot of money. Why not just buy the stuff from your own banks? It would have been a lot cheaper than pouring all this money in. So the fear was a standard contagion thing that, if there's a run on Greek or Irish or these smaller Portuguese banks, you could have a panic that would flood through France and Germany and you could have a financial crisis even though these are small countries with small amounts.

Now, the key thing to remember, if it was just these little countries, Greece and Ireland and Portugal, this wouldn't be a big deal. Put it this way, Greece and Ireland, their GDP combined is the amount that the state of Pennsylvania generates. It would be very hard to believe that if the State of Pennsylvania was in a financial crisis, the rest of the U.S. would say, "oh, my God, we're going to collapse, we've got to get rid of the dollar." That's the point. If these small countries were—they're like the canary in the coal mine. They're telling you there's a problem coming, and the problem is called Italy and Spain. Because these are big economies. Italy is the third largest borrower in the world by GDP. It has about 2 trillion euros of debt outstanding, half of which is held outside of the country by foreigners. This year alone, Italy needs to rollover 300 billion euros. Remember that number of the total package was 750. Italy alone needs 300 billion just this year. That's bigger than the entire Greek debt. Spain, their debt is about 735 billion, and they need to rollover 175. So between Italy and Spain, they need $500 billion of financing this year. So this is where the issue comes in. It's these two relatively large countries that have gotten themselves into some kind of fiscal problems.

So here's the tough fiscal road. As we said, with austerity these are typically the options you have. You can increase taxes, you can cut spending or you can just print money to pay for things and inflate it away. In fact, the U.S. did this. At the end of the Second World War, we ran inflation of about 10 percent for three, four straight years. And by some estimates, that wiped out about 40 percent of our debt. We didn't default, but we didn't quite give you back what we promised you in real terms. Now, the thing is, it's inevitable that when you do these things, you are going to impose costs on people and some pretty severe costs. They fall on different groups. You tax, you cut spending. Those are potentially very different groups. You inflate it away. That's a different group. And so one group says, "I don't want to bear this cost, you bear it." The other group says, "I don't want to bear it, you bear it." So you get political conflict which is exactly what we saw in the last couple of weeks in these elections in Greece and France. And political conflict means delay in getting your fiscal situation on firmer ground. What did we see with the Greeks? The government was elected, they had three days to form a coalition, couldn't even do it. So, you try it again, it failed, then what happens? You can't even get a government to form over this. So the minute you have a political conflict, this is going to erode investor confidence who says, "Am I going to get paid back? Ah, maybe not." So all of this stuff just kind of snowballs on itself.

Now, it became clear last summer that the initial round of assistance from the EU and the IMF was not going to be enough. I just tried to show you the magnitudes. It was not going to be enough to support the Italian and Spanish debt. So last year an extra 340 billion was provided by the EU. And in December of 2011 the European Central Bank finally had to step in and start printing money to finance this borrowing. They poured a trillion euros of liquidity into the European banking system. What kind of shocked many of us was how well that worked for a while. The market seemed to calm down, interest rates seemed to come back down for these countries, everything seemed to be okay. But in a sense, you can see what the ECB did was they said, we're going to provide this trillion euros of funding for three years and then that's it. So interest rates on three-year debt came down. After three years, eh, not so much. Because the general view was, what are you doing? You're just kicking the can down the road. But the hope was that three years would be enough to help these countries get their fiscal houses in order.

Well, inevitably in March of this year, kind of the inevitable that many people said was going to happen two years ago, 80 percent of the Greeks' private creditors agreed to a bond swap, effectively trading old bonds for some new claims. But effectively this restructuring just meant they weren't going to pay you back about half of the debt they originally promised. So even though you agreed it was voluntary to take a 50 percent haircut on your debt, only 80 percent of them agreed to do it. So this effectively meant the Greeks defaulted on half of their debt. And because those 20 percent did not agree to this and they got the haircut, that triggered those default insurance claims. So they were actually realized they had to be paid off.

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