More Help for Wounded Greece Creates More Trouble for Other EMU Members

June 26, 2011

An axiom among economists and investors is that the if the symptoms but not the causes of structural problems are addressed, the ultimate cost of repairing the problem will rise proportionately with the length of time that policymakers do not fix the real problem.  Weekend press of the EU/IMF/ECB’s approach to Greece, providing aid in return for more fiscal austerity in that country, was highly critical.  It is now taken as a fact that Greece is insolvent and will eventually restructure by design or force of circumstances. 

The timing of the day of reckoning is uncertain.  Early last week, it seemed possibly imminent, but German Chancellor Merkel relaxed her insistence that private investors accept lengthening the maturity of Greek debt and Prime Minister Papandreou narrowly survived a vote of confidence.  The elevation of Greek interest rates is a barometer of not only the likelihood of a Greek restructuring but its timing, so those two developments provided some relief for Greece.  The premium of Greek 10-year sovereign bonds relative to German bunds widened from 1457 basis points on June 14 to 1537 bps on June 16 but then moved in to 1399 by the end of last week.

What proved to be a temporary reprieve for Greece was deemed more worrisome for other EMU members, however.  The latest delay increases the risks of contagion.  By not facing up to the inevitable, Greece’s debt problem will be more expensive to treat, and the possibility of a disorderly default rather than one carefully orchestrated by policymakers has increased.  In the ten days between June 14 and June 24, 10-year bond spreads versus German bunds widened by 40 basis points in Spain and Italy, 81 basis points in Ireland’s instance and 98 bps for Portugal. 

This is opposite to the result that leaders of those other countries were expecting.  The thinking has been that a Greek default must be avoided at all cost, lest a chain reaction of contagion ensue just as occurred after U.S. authorities let Lehman Brothers go bankrupt.  As it dawns on these authorities, that repeatedly buying Greece more time actually worsens investor confidence in their own situations, there may be more second-guessing of their current strategy and a lessening predisposition to bail out Athens.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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