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Economic Reality: Nowhere to Run, Nowhere to Hide, Part 2


The onset of the Global Sovereign Crisis marks a new dangerous phase of the credit crisis.

Editor's Note: This is Part 2 of a two-part series. Click here to read Part 1.

It Always Ends in the Same Way

No one, including the IMF, seriously believes that the austerity program announced by Greece will work. Argentina had debt to GDP of around 60% and a budget deficit of 6%. Adjustments necessary to halve both failed. After a long-drawn-out struggle between 1999 and 2001, Argentina was forced to reschedule its debt and have still not quite made its way back to normality. Many of the vulnerable countries in Europe are in a much worse position than Argentina in 1999.

Rapid economic growth or high inflation would improve Greece's prospects for survival. Neither is a realistic option. The eurozone could continue to finance Greece, which would require extension of the current package, which is initially for three years.

Greece may not be able to avoid a debt restructuring. For the countries like, Ireland, Spain, Portugal as well the others, the savage austerity measures required are unlikely to be palatable and probably won't work in any case. All roads may lead eventually to debt restructuring.

The best course of action for Greece would be to "temporarily" (that is, for the next several hundred years) opt out of the euro and unilaterally re-denominate its debt into the "new" drachma. Through the currency devaluation, this would effectively reduce debt and restore competitiveness. In any debt rescheduling, lenders would take significant write-downs, reducing Greece's debt burden, giving it a chance to emerge as a sustainable economy.

The real agenda of the bailout is to avoid foreign lenders taking large losses. The investors were imprudent in their willingness to lend excessively to countries like Greece assuming EU "implicit" support and are now seeking others to bail them out of their folly. As Herbert Spencer, the English philosopher, observed: "the ultimate result of shielding men from the effects of folly is to fill the world with fools."

As at June 2009, Greece owed US$276 billion to international banks, of which around US$254 billion was owed to European banks with French, Swiss, and German banks having significant exposures. Bank for International Settlement data indicates that German and French banks' exposure to Greece is about $50 billion and $75 billion respectively.

In aggregate, the exposure of Germany and France to troubled European countries is around $1 trillion. According to the Bank for International Settlements, as at the end of 2009, French banks and German banks have lent $493 billion and $465 billion respectively to Spain, Greece, Portugal, and Ireland.

The real purpose of the bailout is to prepare for a possible series of sovereign debt restructurings in Europe. In an ideal world, banks and investors raise capital and write down their exposure to the troubled debtors over time allowing the restructuring to be relatively smooth, avoiding disruption to financial markets.

Dysfunctional Functionalism

Contagion is already a reality. Highly indebted sovereign borrowers with immediate financing needs are facing higher costs and lower availability of funds. Scrutiny of their public finances is forcing them to adopt austerity programs to remain credible borrowers with access to markets.
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