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‘Slow motion’ Greek train wreck gets ready to hit another buffer

By Paul Hodges on 10-Jun-2015

Train wreck1The key issue in the Greek debt crisis is easy to understand,.  It is that Greece’s GDP last year was just $238bn, whilst its debts are estimated at €322bn ($365bn).   So Greece is clearly going to default at some point.  The problem is that no policymaker is prepared to admit this obvious fact, as they are frightened of what might happen as a result:

  • The German and other Eurozone governments are terrified that their electorates might discover they are in line to pay the bill for Greece defaulting on its debts.  The German part of the bill could easily be €86bn, and in a worst case could be the entire €322bn according to the respected IFO Institute
  • The Greek government is also terrified that it will be thrown out of office if it doesn’t follow through on its recent election promises to end austerity, and establish a European version of Roosevelt’s New Deal

Meanwhile, everyone outside the negotiations stays calm, because they assume that in the end, both sides will agree another ‘pretend and extend’ deal that avoids the need to tackle the key issue.

January 2009 saw the first signs of trouble, when Greece’s credit rating was downgraded.  The shock of the financial crisis meant some people now realised debt had to be repaid, and couldn’t just be rolled-over forever.

By May 2010, the first Greek ‘rescue package’ had been agreed.  At the time, I followed the example of investment manager Jeremy Grantham in describing it as a train crash:

In July 2007, he coined the term ‘slow motion train wreck’ to describe the coming Crisis. And back in August 2008, the Financial Times helpfully pointed out that in economic crashes “there are pauses before the next carriage hits the one in front“. It added that “this explains how we have since moved from crisis to crisis, with rallies in between, as participants persuade themselves that the worst is over.”

At the time, the cost of restructuring Greece’s economy was supposed to be just €30bn in government cuts, and €110bn of loans from the Eurozone and the IMF.  But one warning sign was that even this level of cuts was going to keep Greece in recession till 2017.

And so in July 2011, 21% of Greece’s then €350bn debts had to be written off.

But by May 2012, it was clear this had been “too little, too late“.  Greece’s debt had apparently reached €400bn – whilst GDP had fallen 20% since 2008.  At this stage, many began to lose faith in the published numbers for the debt.

But the political leaders pressed on with the ‘pretend and extend’ concept.  Put simply, the lenders told Greece to ‘pretend’ it would repay the loans: in return, they promised to ‘extend’ repayment out as far as 2050.

The core issue is that Greece was a poor country when it joined rich countries such as Germany in the Eurozone in 1999.  Its GDP/capita was just $11k.  Only full political union could have made this a workable arrangement – with the precedent being the deal between the two Germanies after the fall of the Berlin Wall.

Back in 1990, when the concept of the euro was first discussed, political union was indeed high on the agenda.  German Chancellor Kohl and French President Mitterand publicly agreed it was essential that to hold “an intergovernmental conference on political union” alongside that proposed for economic and monetary union.

But of course this never happened.  In the end, France refused to surrender its national sovereignty.  In turn, Germany refused to move forward without having central controls in place to control tax and spending policies.

So instead, everyone decided to pretend that political union existed.  And the banks (often state-owned) lent large sums to poor EU members such as Greece, assuming that Germany would pay the bill if something went wrong.

Needless to say, this was the worst possible option.  The banks lent, and the Greeks spent, but nothing was done to ensure repayment was possible.  It was classic ‘Ponzi Lending’ as defined by Hyman Minsky.

And then in 2012, the ‘pretend and extend’ policy made a bad situation even worse.

In a corporate bankruptcy, the lenders have to sit down with management and either agree to closure, or to refinance. Refinancing usually means swapping the debt for equity, and then putting in new money to help the company rebuild for the future.  But this has never happened with Greece:

  • Instead, the new money it received went largely to repay the German and other banks who had made the loans
  • Very little new money went to rebuild the Greek economy
  • Understandably, the government therefore gave only paper commitments on tax, pension and other reforms
  • In addition, a delayed repayment schedule was agreed, in some cases out to 2050
  • This meant the other Eurozone governments could pretend to their electorates that their money was safe

One obvious lesson from the crisis is that we lack leaders who are prepared to stand up and speak the truth to their voters.  Instead, they prefer to hide behind the “figleaf” of monetary policy and pretend everything will soon be fine.

So it would be no surprise if another deal emerges again this time.  But this will not solve the Greek problem.  It will just increase the debt still further until one day, something finally upsets the ‘pretend and extend’ policy.

When the Greek domino finally falls, the lenders will in turn be unable to pay their debts.  I fear a most unpleasant reality may then follow the game of ‘pretend and extend’.