The euro, which has been falling for months, rallied yesterday as markets grew slightly more confident that Germany would bail out Greece. For years, the strong economies of Europe have insisted that no matter what, they were not responsible for the debts of other eurozone nations. However, this policy may be changing.
Is Greece Europe’s Fannie Mae? The US corporation, put into government conservatorship in the dark days of September 2008, flourished for years because of an implicit guarantee from the federal government. Markets took the guarantee seriously, allowing Fannie to borrow at preferential rates, only a few basis points over comparable treasury bills. Shareholders and management made out like bandits, exploiting their huge funding advantage over other financial companies. Even as Fannie became dangerously overleveraged, markets shrugged off the risk. They knew Uncle would come to the rescue should anything go wrong.
By joining the euro, Greece, and its fellow Piigs countries (Portugal, Ireland, Italy, Greece, and Spain), have been able to borrow at rates almost identical to Germany, even though the German government is much more credit worthy and the German economy much stronger. On the face of it, it is bizarre that stolid Germany should pay the same rate as flighty Italy, but for years bond yields of the Eurozone nations converged as markets ignored the different levels of credit risk posed by the various governments.
In the early years of the millennium, joining the euro was great for the Piigs. They were awash with cheap money and easy credit, just like Fannie over in America. This fuelled a boom, financing trade deficits, allowing consumption, both public and private to zoom to unsustainable levels. But being locked into a single currency, they no longer had the option to devalue and so their less efficient economies lost competitiveness.
Today, Greece has a 12 per cent of its GDP budget deficit, its government debt is 124 per cent of GDP, and its trade deficit is 14 per cent of GDP. Credit default swaps prices suggest that markets are expecting a 5 per cent chance that Greece will default and it needs to borrow $30 billion in the next few months, $75 billion by the end of the year or it will go bust. Financial markets, which a few years ago were yield hungry have lost their appetite for risk and Greece might have a hard time selling its debt.
The dangers for Europe are immense. If Greece goes down, if bondholders conclude Europe won’t bail it out, Spain could be next. German taxpayers might be willing to afford to save Greece (its economy is only 2 per cent the size of Europe’s) but Spain is much larger; a bail out that much more painful. And banks all over Europe hold Greek debt. A default would devastate their still fragile balance sheets.
Germany is naturally loath to bail out the spendthrift Greeks but I suspect they fear that if they do not, if Greece doesn’t become Europe’s Fannie Mae, it could become Europe’s Lehman Brothers and that would be far worse.
