30 Jun 2011

What Happens When A Country Is Too Big To Fail?

We're about to find out.

Greece, of course, is that country. And it is both too big to fail and bail because of the complex linkages of debt in the Eurozone, fuelled by years of reckless lending (or borrowing…take your pick).

There is too much at stake for the European bureaucrat/banking elite to allow a Greek default at this point. An apparent pre-condition for an emergency release of 12 billion euros – and a subsequent second bailout of 120 billion euros – is the passing of new austerity measures by parliament tonight .

The likelihood is the politicians will vote yes. Many have indicated an initial willingness to reject the austerity vote. But there has been a concerted effort by all vested interests to create an environment of fear of economic collapse should Greece default. Very few politicians have the gumption to stand firm under such pressure.

So the vote will pass. And even if it doesn't, the EU will find a way to provide Greece with the emergency funds it needs, giving time to coerce or bribe those not sold on austerity.

According to Reuters, 'It is conceivable that even without aid, Greece could roll over some 4.4 billion euros of three- and six-month Treasury bills due to mature on July 15 and 22, but it is expected to be unable without aid to redeem 5.9 billion euros of five-year bonds it has falling due on August 20.'

Now, here's why the can-kicking exercise will prolong the pain, add to market uncertainty (after the initial adrenalin rush) and make the problem larger down the track.
The maturing debt is due to be repaid to private investors. The bailout funds are not going to Greece, (not in their entirety, anyway) they are simply repaying private investors who made very bad lending decisions. Greece's debt hasn't shrunk. It simply has new creditors…the funders of the IMF and taxpayers of the Eurozone.

The bureaucrats are under the illusion that asset sales and austerity measures will allow Greece to grow out of its debt problem. They assume these measures will enable Greece to return to the bond market next year and borrow from private investors, rather than the IMF and the Euro bailout fund.

That was the plan with the 2010 bailout but the bond market has become even more hostile towards Greek debt. 10-year yields are currently a prohibitive 16 per cent. So the bureaucrats now think even deeper austerity measures (and another 120 billion bailout) will do the trick by next year.

Look, the Greek economy is about as dysfunctional as you can get for a developed economy. It needs deep reforms on many levels, including pensions, the public sector, tax etc.

But carrying out reform, for the benefit of the European banks, will not work in a country with 16 per cent unemployment and 42 per cent youth unemployment. (That was from March, it's probably higher now). Civil unrest will continue until the lenders share responsibility for making stupid loans.

For every bailout though, the costs of an eventual and inevitable default move onto the public. This is probably the strategy. Kick the can for as long as you can and when the banks have been repaid and offloaded enough debt to the European Central Bank, organise a restructure.

Meanwhile, these actions send out extremely damaging long-term price signals. What I mean is that by failing to punish poor, highly risky lending decisions, bankers/traders/speculators just take on greater risks. Capital continues to be misallocated and greater economic distortions build up over the long run.

So instead of having a nasty but short-lived economic and financial shock, as a result of a default and debt restructure, you'll get prolonged economic malaise, which will in turn lead to more meddling and government 'fixes'.

This is the unsettling reality of trying to manage your wealth in 2011 and beyond…

For a long but comprehensive read on the complexity of the mess that is Europe, check
this article out. It's written by Satyajit Das, the Indian/Aussie credit/derivative market expert who saw the first credit crisis hit well before the pack. This article is a great hindsight look at Das's foresight.

So what does all this mean for global and Aussie markets? Reprieve, for the time being.

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