Europe Stares Into the Abyss

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Like a lot of people, I’ve been trying to figure out whether Europe is doomed. I change my mind on pretty much a daily basis. So let’s take stock. Greece and its massive debt load is Europe’s immediate problem, of course, so here’s some advice from Mario Blejer, who managed Argentina’s central bank after they defaulted on their debt in 2002:

This debt is unpayable. Greece should default, and default big….It doesn’t make sense to give money to Greece so Greece can pay the Germans back. All these projects, all the euro projects don’t make sense economically.

Kyle Bass, managing partner of Hayman Capital, agrees: “Greece has to default,” he says. “It’s going to be a hard default, and then it’s going to be difficult to contain this contagion.”

Roger that. Greece just flatly can’t pay off its debts and will probably never be able to pay off its debts. So repudiation is inevitable, and Blejer is worth listening to on this score since Argentina has done fairly well since its crisis and subsequent default. There’s more to this story, though, because Argentina didn’t just default. They also abandoned their fixed peg with the dollar and allowed the peso to float, which resulted in a quick and massive currency devaluation and enormous inflation. After a period of intense pain, the devaluation worked: Argentine exports rebounded strongly because they had become so cheap, and this eventually revived the economy. But Blejer doesn’t think that Greece should leave the euro, which seems odd at first since it’s functionally equivalent to abandoning a currency peg, something that was part of the formula for Argentina’s recovery. However, it’s perfectly understandable if Forbes’ Cyrus Sanati is right about what would happen if Greece abandoned the euro and switched back to a drachma that it then immediately devalued:

Moving back to its former currency would allow Greek exports to be competitive again with its neighbors, especially those that cater to tourists. Across the Aegean in Turkey, GDP grew by 8.8% in the second quarter. There is no reason why Greece couldn’t capture some of that tourist market if it returns to a cheap currency.

But leaving the common currency would also lead to some nasty results. It would force Greece to raise cash to plug its budget shortfall and potentially pay yields that could run as high as 25% over German bonds, something that would probably be impossible. That would force Greece to make even larger cuts in government spending, further exacerbating its economic woes. The Greek banking system would almost certainly collapse in the changeover as the ECB would stop payments currently keeping them afloat. Without that cash infusion from the ECB, the Greek banks would be left with a massive funding gap equal to around 20% of their assets or 100 billion euros, according to an analysis by Citigroup.

A run on the Greek banking sector would result bringing economic activity in the country to a grinding halt. Imported products would be in short supply, creating serious political and social unrest throughout the country. The ensuing collapse in the Greek banking system would send shockwaves throughout Europe.

This is the rub. When Argentina abandoned its dollar peg and devalued its currency, it only affected Argentina. If Greece were to abandon the euro and replace it with devalued New Drachmas, it would affect the entire euro area. Every weak country in Europe would face crippling bank runs. After all, if you thought there was even the slightest chance of your deposits in, say, Banco de Santander or Banca Di Roma, being forcibly converted to New Pesetas or New Lira worth half what you deposited, you’d hustle over and pull out your money while the pulling was good. All of it. Pretty much every bank in Spain, Portugal, Italy, and perhaps a few other countries as well would be obliterated.

So this is basically where we’re at. Greece can’t pay its debts. Everyone and his dog knows this. But if Greece defaults and leaves the euro, you get the massive economic collapse and bank runs described above. Gavyn Davies says this is apparently no longer on the table:

Germany was reported to be examining these radical options at the weekend. However, having looked over the precipice, Angela Merkel, German chancellor, seems to have recoiled from them, for now. We will learn more in the next few days, but yesterday she hinted that she would still prefer a delayed, “orderly” Greek default, rather than an immediate and disorderly one. Unfortunately, neither option looks very appealing.

No indeed. But then, none of the other options look very appealing either. The only real option left is for Greece to default and for Europe’s rich countries to recapitalize all the banks that would otherwise go bust thanks to their exposure to Greek bonds. But then what? Even with no debt, Greece is still a basket case, and as long as they stick with the euro there’s no way to turbocharge their export market with a currency devaluation the way Argentina did. So then what? Either Europe continues to provide massive amounts of assistance for years to come, or else Greece collapses. And quite possibly a few other countries follow suit.

So as much as everyone hates the idea, massive amounts of assistance for years to come is probably the best bet. Apparently Merkel and other EU leaders are finally starting to realize this deep in their bones. It’s infuriating, but the alternative isn’t mere bank recapitalization and aid to Greece (which is galling but tolerable), it’s continent-wide bank runs, further defaults in other countries, and the collapse of the euro. Merkel is finally looking into the abyss, and the abyss is looking back.

As for me, I guess I’m feeling slightly more optimistic about things today than I did a couple of days ago. But next week might be a different story.

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