From John Hussman, some thoughts on what more and more people see as inevitable: A Greek default, and what should/will come next.
The gist: The ECB does everything it can to stem contagion into Italy and Spain (heavy bond buying), more restrictions on euro membership, and a stabilisation of the banking system.
So Greece will default, either now or within several months. In response, three actions will be critical: preventing contagion, preserving the euro, and stabilizing the banking system.
First, and most immediately, European leaders will have to prevent contagion. As I noted two weeks ago, Italy and Spain are the most worrisome targets of contagion, but even though they are large and have high debt-to-GDP ratios, there is no credible risk of default in these countries in the foreseeable future. So the ECB should absolutely be willing to extend its purchases of Spanish and Italian debt. Even the U.S. Federal Reserve, which is authorised to purchase foreign government debt under Section 14 of the Federal Reserve Act could provide significant stability by initiating even modest purchases of Spanish and Italian obligations (purchasing Greek debt, on the other hand, would wander unconstitutionally into fiscal policy, since the likelihood of default is so high). The key to stopping a contagion is to delineate which countries absolutely belong behind the firewall, rather than behaving as if all of them do.
As for the euro, the best chance for a durable currency is to restrict its membership to countries with similar macroeconomic characteristics that are actually capable of following a very uniform budget discipline. Neither a single central fiscal authority for all of Europe, nor the issuance of “Euro-bonds,” are useful ways of achieving this goal. There is too much economic heterogeneity and too much cultural individuality in Europe for all of these countries to surrender their fiscal policy independence away from their own citizens. Meanwhile, “Euro-bonds” would represent an effective subsidy and guarantee from more stable European countries to less stable ones, and would encourage moral hazard and fiscal recklessness the likes of which the developed world has never seen.
Ultimately, the only way to preserve the euro is to remove its fiscally unstable members from the formal currency arrangement. Peripheral European countries could potentially substitute that with a pegged exchange rate. Of course, even a pegged exchange rate can lead to a currency crisis if fiscal discipline is weak enough, as we saw a decade ago with Argentina. Still, it would be far better for countries such as Greece and Portugal to redenominate into their own currencies, and peg them to the euro, than to bring down a system that works very well for the majority of European citizens.
The third policy response, of course, would be to stabilise the banking system. My own view has always been straightforward – investors and institutions that voluntarily accept risk in order to reach for extra yield should be prepared to suffer the losses if those investments fail. Nearly every major financial institution has enough shareholder capital and debt to its own bondholders to absorb losses without any loss to customers or counterparties. Financial institutions that become insolvent as a result of bad investments should be taken into receivership and recapitalized under new ownership – with the existing shareholders wiped out, and the existing bondholders receiving the residual (which in most cases is 100 cents on the dollar for senior debt anyway, and often close to that even for subordinate debt).
In any event, however, whatever public funds Europe wishes to use in order to address this crisis should be directed to replenishing the capital of banks (ideally, restructured ones), and providing emergency capital to a post-default Greece. This is in Europe’s best interests, and it is in Greece’s best interests, because however longingly policy makers would like to imagine that further bailouts can prevent a Greek default at its current level of debt-to-GDP, the arithmetic simply does not work that way. The time for changes to fiscal policy was years ago, well before the Greek debt-to-GDP level scaled its current heights. Europe will now have to play the hand that has been dealt.
So, unfortunately, will the United States. According to Fitch Ratings, the 10 largest U.S. prime money market funds had total assets of $658 billion as of July 31, 2011. Of those assets, $309 billion – an unsettling 47% of the total – represented debt obligations issued by European banks. It is unclear what level of subordination these debt obligations take, but we can expect that in the event of a Greek default, this concentrated ownership of European bank debt by U.S. money market funds will be less than ideal for investor confidence. (As a side note, the money market assets held by the Hussman Funds are in U.S. Treasury funds.)
I can’t imagine what the yield-reaching managers holding European bank debt are thinking, but if last week’s agreement by the Fed to provide dollar swaps to the ECB is any indication, my guess is that the eagerness to send dollar liquidity to Europe is abruptly drying up from private sources. In any case, the heavy allocation of U.S. savings to the European banking system strikes me as an awful example of “moral hazard” produced by two forces: the 2008-2009 bank bailouts, coupled with a European regulatory structure that doesn’t require those banks to hold any capital against holdings of European government debt, including that of Greece. As we saw in the housing crisis, when a weak regulatory structure encourages unaccountable leverage, and irresponsible monetary policies encourage reaching for yield, the combined result is predictably disastrous.
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