When Greece defaults…

…it probably won’t be called that.  Some will note that it is a default, and those who do will be shouted at by “all the cool kids” in Frankfurt. 

Calling it default means that those investors in Greek sovereign debt who bought “credit default swaps” — in essence, insurance against the Greeks defaulting — get to collect on their policies.  But collecting on those policies will be very expensive for, um, the cool kids.  So they won’t call it that, so the insurance policies won’t pay off.  No matter what Fitch says,

“It is going to happen. Greece is insolvent so it will default,” [said] Edward Parker, Managing Director for Fitch’s Sovereign and Supranational Group in Europe…”So in that sense it shouldn’t be a surprise to anyone.”

The Fitch comments come after Moritz Kraemer, head of Standard & Poor’s rating agency’s European sovereign ratings unit, said on Monday Greece would default shortly on its debt obligations.

That was last Tuesday, and over this weekend bargaining continued, as the bondholders try to extract a little extra out of their bad Greek bonds.  In short, they have to trade 2 euros of bad bonds for 1 euro of good new ones, paid for by fresh financing from the EU which is to meet Monday.  Greece has until March to get this settled; that’s when many of the old bonds come due.

What happens if they don’t?  The Financial Times offers a nice graph describing the options.  If they work out the deal, the game continues.  There are no defaults (at least, none anyone wants to recognize), the EU ministers continue to negotiate their closer fiscal union (a/k/a, “we’re all Germans now!”) and the money shows up to back the weak periphery currencies.  It keeps hope alive.  That’s a bit of a problem for us in the US, because until the details are worked out the dollar strengthens, which is great for Ricocheteers traveling to Europe but lousy for the farmers here in central Minnesota. When the deal is finalized the euro strengthens, reversing the trend. That’s the optimistic outcome.

Suppose Greece has to leave the eurozone.  It needs to because it needs foreign exchange to pay for these bonds, and the only way it can do that, eventually, is to reduce the real value of its workers’ wages by introducing a new drachma, reduce its value versus the euro, and thus improve its ability to pay off debt with cheaper currency.  (Explanation from John Mauldin.)  The Germans don’t want this and that’s why they are helping out Greece.  But the pressure in Germany to stop this, to stop bailing out perceived Greek profligacy, will eventually force Merkel to relent and permit the Greeks to leave.  The new bonds being negotiated will have stipulations on what happens if Greece leaves the eurozone.  (I don’t know that, but it would be foolish to do otherwise.)

The part we can’t predict and must watch for 2012 is how the other periphery countries, the PIIGS-less-the-G, respond to whatever is worked out for Greece.  Because Greece is the precedent, an extralegal ad hoc workaround the Maastricht Treaty that created the euro.  Make the terms too generous to Greece, and you invite Portugal and Spain to seek similar terms.   Of course, Europe cannot afford to offer those terms to Portugal and Spain.  But make it too harsh, and Merkel will be explaining why Greece needs another bailout in the next election, one she would likely lose even if she could survive an intra-party revolt.  Her fate is tied to Athens, despite her every attempt to spin away.

Let me point to one path in that FT chart that most people ignore.  Merkel’s hole card in the negotiations over Greece and the fiscal union is the threat of leaving.  What would the eurozone be without Germany, particularly if it could take Netherlands, Austria and maybe Finland with it?  It would die.  I am not predicting it will happen, but don’t be surprised if it becomes a speculation more widely discussed in 2012.

  1. Sisyphus

    Greece has defaulted, the banks involved were strong armed into accepting a “voluntary write off” to avoid triggering their hedge arrangements to calamitous result, as you say. Greece debt will soon be just another brand of toilet paper. The only question is how much of Europe will Greece be allowed to take down in the process.

    The real heart of the issue is that the only buyers of such paper left are idiot governments and institutional buyers under the brutish thumbs of idiot governments. The real victims are the people under the idiot governments, getting the government they deserve. Good and hard. (Apologies to H.L. Mencken) Did I mention that the US is one of said governments through its relationship with the IMF?

  2. Joseph Eagar

    This reminds me of what I’ve read about the Bretton Woods system, back when the international policy community was still hoping to make it work.  The choice came down to forming a quasi world government, or breaking up Bretton Woods.  Nations being nations, they chose–for the most part–to float their exchange rates.  The framers of the eurozone learned this lesson well: to maintain a fixed exchange rate system, nations must give up their ability to go back to their own currencies.

    Only then, will national populations accept economic harmonization, fiscal union, and ultimately the forced creation of a new state, independent from the democratic wishes of it’s own people.  So the theory goes, anyway.  We’ll see if the eurozone framers succeed.

  3. billy

    How about we get a Ricochet pool going on which American state will default first?

    I say Illinois.

    Any takers?

  4. Sisyphus
    billy: How about we get a Ricochet pool going on which American state will default first?

    I say Illinois.

    Any takers?

    I’m going with California under Governor Moonbeam.

  5. Diane Ellis
    C

    King, you say that the Germans don’t want Greece to leave the Eurozone. Why, exactly, is this?  Wouldn’t the Eurozone be better off without a troubled Greece?

  6. DocJay

    Diane, there is no acceptable exit strategy yet. All those outlined above and other exit strategies not publicly discussed have so much collateral damage that multiple entities are vying for who takes the hit. The lengthy slow burn has allowed the ultra wealthy Greeks to hide their money as well as sovereign banks time to pass off as much bad debt on taxpayers as possible.

  7. Mendel
    Diane Ellis, Ed.: King, you say that the Germans don’t want Greece to leave the Eurozone. Why, exactly, is this?  Wouldn’t the Eurozone be better off without a troubled Greece? · 19 minutes ago

    A large number of German banks are exposed to Greek debt and constantly lobby the government and the ECB to prevent those investments from tanking.

    There is also a strong sentiment among the German public that says, for political/symbolic reasons, no country may leave the Euro.  I know many Germans who see the trainwreck coming with open eyes, but feel that the symbolism of a united Europe is the absolute highest imperative.  It is amazing how many Germans are willing to fork over their own tax dollars to keep this doomed tax project intact.

  8. Joseph Eagar
    Diane Ellis, Ed.: King, you say that the Germans don’t want Greece to leave the Eurozone. Why, exactly, is this?  Wouldn’t the Eurozone be better off without a troubled Greece? · 19 minutes ago

    The Germans fear a Greek exit would lead to a general balance of payments crisis (a currency and banking collapse rolled into one), as investors fled the euro for safer havens.  If this happened, it would almost certainly throw the world back in recession (and the eurozone into depression).

    An orderly Greek exist is possible, but only if the market has lots and lots of lead time, German and French banks are bailed out by their governments, and Spain and Italy make progress in their own fiscal programs (so the market will believe they won’t be next).

  9. flownover

    You guys need to realize that Ch 9 rights and states are a very iffy combination. As it is presently, Ch 9 filings are being rebuffed all over. There have only been 600 some filings total since the law was enacted in 37. Harrisburg is having problems with theirs,as is Jefferson County Alabama. 

    That a state would default would be astounding. Writs of mandamus are a pipe dream for the people on Detroit right now. And from that sprung Ch 9.

    Countries can devalue, coalitions can reform, states can default to whom ? Meredith Whitney ? call your agent ..

  10. Stephen Bishop

    This really is an example of stuck thinking. Greece has one, a debt problem and two, an expenditure problem. For the expenditure all they need to do is introduce legislation reducing all remuneration contracts by 25% in value. As far as the debt goes they have lots of islands which can be sold off. I’m sure there are Northern European states would like some space in the Sun. The UK would be quite happy to take Corfu as there is already a cricket pitch. The Germans are the biggest creditor so they can have the biggest island Crete. Now who would like Lesbos?

  11. Joseph Eagar
    Stephen Bishop: This really is an example of stuck thinking. Greece has one, a debt problem and two, an expenditure problem. For the expenditure all they need to do is introduce legislation reducing all remuneration contracts by 25% in value. As far as the debt goes they have lots of islands which can be sold off. I’m sure there are Northern European states would like some space in the Sun. The UK would be quite happy to take Corfu as there is already a cricket pitch. The Germans are the biggest creditor so they can have the biggest island Crete. Now who would like Lesbos? · 1 minute ago

    Except they don’t have the technical expertise to enforce such a law.  Remember when the Greeks had to raise electricity prices, because they simply don’t know how to collect taxes?

    Besides, Greece cannot balance its budget without a healthy private sector any more than it can without cutting public wages.  Deregulation and strengthening competition in protected industries will be key to that.

  12. K T Cat

    I would think that not triggering the CDS payoffs will in itself cause a crisis.  It will most certainly be a default by Greece and not following the rules of defaults will show all investors that there are no rules save those that benefit the governments.  The best option then is to get out of the market as fast as possible.

    In any case, Greece would seem to be a sideshow.  The real bomb that will go off this year is Italy.  If the CDS payoffs haven’t been made in the case of Greece, then those $400B+ in Italian bonds that will need to be bought in 2012 will go begging.  Only a total idiot would invest in them then.

  13. Ottoman Umpire

    What would happen if the Eurozone were to dissolve?  The helpful graphic from the FT ends in a big red box that says that we’d have legal disputes over all euro contracts, but would that really lead to worldwide or even regional economic meltdown?  

  14. Herkybird
    King Banaian: 

    Merkel’s hole card in the negotiations over Greece and the fiscal union is the threat of leaving.  What would the eurozone be without Germany, particularly if it could take Netherlands, Austria and maybe Finland with it?  It would die.  

    The Deutschemark and the Swiss Franc were, pre-EMU, the benchmark currencies of Europe.  I would guess that a German withdrawal from the Euro and a return to the Mark would be pretty painless for the Germans?  That would make a second-tier economy like France the touchstone.  Yes, the Euro would surely lose value but wouldn’t that make unwinding the Euro a little less traumatic for the remaining countries?

    I ask this while thinking of Herbert Hoover’s contention that the cause of the Great Depression involved post-Great War Britain returning to the Gold Standard and pegging Sterling at $4.65, when the market suggested $3.60 was the proper rate. The former rate made British exports uneconomic, where the latter would have led to a painless change in the currency system with only England’s Armour Propre suffering a blow.

  15. King Banaian
    C
    Diane Ellis, Ed.: King, you say that the Germans don’t want Greece to leave the Eurozone. Why, exactly, is this?  Wouldn’t the Eurozone be better off without a troubled Greece? · 3 hours ago

    Germany exports a great deal to Greece, about 13% of all Greek imports (Italy 2nd at 12%, nobody above 6%.)  That comes to net exports to Greece over $8 billion. The value of those fall if Greece switches out to the drachma because German exporters have to protect themselves from changing exchange rates between the euro and the new drachma (or the new mark and …)

  16. King Banaian
    C
    DocJay: Diane, there is no acceptable exit strategy yet. All those outlined above and other exit strategies not publicly discussed have so much collateral damage that multiple entities are vying for who takes the hit. 

    It’s not for lack of trying.  Bob Barro had a column two weeks ago with one suggestion.  @Herkybird’s suggestion of getting the price of a new mark or drachma right is important, but it could be messy as each country tries to out-devalue the other.  

    @Ottoman Umpire asks how bad the disruption would be of resolving disputes over the post-eurozone world’s value of euro contracts.  That’s a big question and many people have taken a whack at it.  Try the analyses of UBS or Barry Eichengreen, to name just two.

  17. King Banaian
    C
    Stephen Bishop: Greece has one, a debt problem and two, an expenditure problem. 

    To be more precise, it has an expenditure-on-foreign-goods problem as well as a government expenditure problem.  It needs to reduce its government spending, but it also needs a way to get back to a trade surplus.  GDP growth would improve, and drain on foreign reserves would stop.  Without an exchange rate adjustment vis-a-vis northern Europe, I do not see how they do that.

  18. Steve MacDonald

    Fascinating watching this play out:

    1. Bond holders purchase thinking they are primary * find out they are really at the back of the line, behind ECB and sovereigns. Rebelling hedge funds may seriously complicate.

    2. Current attempt at agreement still leaves Greece at debt/GDP of 120%, which as Italy knows, is not a comfortable place to be. not only that, it still leaves Greece uncompetitive vs everyone.

    3. Portugal will follow regardless of best intentions. Ireland has signalled it wants “help.”Spain and Italy heading for the vortex. Belgium?

    4. Banks and finance industry in serious trouble, and who has money to nationalize/reflate besides the northern countries?

    I don’t see how they can go on much longer without exiting at least Greece and Portugal. Even if they do, this looks like it is going to get profoundly ugly.

    Question: When Europe gets sorted one way or the other, who’s next?

    a) Japan

    b) USA

    c) Both

  19. Steve MacDonald

    Of course this may get hugely more “interesting” if CDS get triggered. I don’t think anyone knows how that would unwind – except that it would be catastrophic.

  20. Steve MacDonald

    Two questions for King:

    1. What IF national and economic self interest take the place of political elite posturing – What if Germany listened to its electorate and refused to put good money after bad, using funds to reflate its banks instead. European export markets are severely damaged already but riding the Euro down makes outside zone exports increasingly competitive. When inflation starts to bite, the DM comes back, partially backed by their substantial gold holdings. Liquidity floods in to the new currency backed by something tangible (as China and Russia appear to be heading towards). North European countries peg to the DM. Is this not a reasonable scenario? What would be the USA reaction towards a credible threat to its global currency dominance?

    2. If the Euro continues to depreciate (crosses 120 and continues down) and China refuses to move its currency upwards (or maybe even moves it down – Europe is its biggest market), how long will it take Ben to move to the new improved QE3? Obviously called by another name but still a bazooka in the currency wars.