Greek Fudge

As most economists have been saying was inevitable, for some time, Greece has defaulted on its debt. But, as has been forecast, for some time, it was not an unplanned default of the kind that would have plunged credit markets into chaos. Indeed, the EU Ministers have gone out of their way to say that it is not a default at all, whilst the ECB President, Jean Claude-Trichet, who was opposed to any deal that involved any kind of default, was non-committal, as to whether it was or not, preferring to leave that decision up to the international credit rating agencies.

In fact, those agencies have made their view clear in previous weeks that any change in the terms of repaying Greece's existing debt, would be a default. That poses problems for the ECB, which has said that in the event of such a default, it could not accept Greek Bonds as collateral against loans. But, that, like the rest of the package, is likely to be fudged.

The Eurozone is to lend Greece a further €109 billion, some of which is to come from a so called Private Sector Initiative (PSI). In addition, the interest rate charged to Greece for the money it has been lent by the EU is to be reduced from 6% to 3.5%, and similarly that rate is to be applied to the EU bail-out loans to Ireland and Portugal. In addition, Greece is to be given 30 years to pay the money back. According to the BBC, the terms of the deal, according to the Institute of International Finance ,constitute a 21% haircut on their loans by Greece's lenders. At best this is just sticking another plaster on a gangrenous wound.

We will have to see what the further consequence of the default are. For one thing, we do not know what the effect will be in relation to all of the Credit Default Swaps (CDS) issued against Greek Debt. A CDS was initially intended to be a a way in which a lender could insure themselves against a default on the loans they make. It meant that if the borrower defaulted the lender could be recompensed by the Financial Institution, which insured them against their loss.

Because, these losses could potentially be large, the Financial Institutions issuing the CDS's, usually packaged them up into bundles, of varying degrees of risk, and then sold these on to other investors, so that they themselves were insured against, or had removed the risk from themselves to others. This, of course, was also the same kind of process that was engaged in with Mortgage Backed Securities, which packaged up sub-prime mortgages into similar packages which were then sold on.

The problem with the derivatives based on MBS's was shown by the sub-prime crisis. If the underlying loan is unsound, because the borrower cannot repay, and if the value of the underlying asset against which the loan was made – a house – is grossly inflated, and rapidly falling in value, then those who are ultimately left holding the baby, in terms of needing to pay out, can be themselves bankrupted. Given that these products were sold extensively, and that no one really knew who was holding the risk – what is known as counter-party risk – then banks and financial institutions stopped lending, keen to ensure they hoarded their own cash in case it was needed, and not wanting to lend it to others for fear they might be about to go bust.

The problem with derivatives based on CDS's is not just that, but as with many more of the exotic products developed in Financial Markets over the last 30 years, it was not just those making the loans who could take out the insurance. In short, it became possible for anyone to buy a CDS, as a gamble that Greece or some other economy might default. It was literally that a gamble, just like betting that there will be a White Christmas. So, the amount of CDS issued could be way more than the total amount of debt issued. And all of those will have bundled up and sold to other Financial Institutions, Pension Funds etc.

But, however, it is dressed up, Greece HAS defaulted. If you had made a bet that it would, you will want to be paid out for making a correct bet, and that means someone has to pay. Of course, the extent of the default is limited, and these kinds of bets are usually laid on the basis of spread betting.

So, in the same way that you can lay a spread bet that England will lose by so many runs in the Test Match against India, and you bet per point of loss, so that the bigger the loss the more you get, so you can lay a spread bet of the amount of default. The limited nature of the default will mean that the extent of exposure will be limited, so this is not likely to lead to any bankruptcies or severe credit event, but in reality we don't know until people start making claims, and others have to start paying out on them.

Either way, this is no solution for the problems of Greece, and the Eurozone. It means that Greece is given more breathing space, which means the EU is given more breathing space to come up with a proper solution. It means the burden of debt for Greece is marginally lessened but only very marginally, reducing its ratio of debt to GDP from about 160% to 140%, but it does not address the fundamental issues. In reality, the Greek debt, as well as the Portuguese and Irish debt needs to be simply written off as a start. That means that the rich Northern European nations, primarily Germany have to pay the bill. That is essentially what they are doing here, but doing so in a piecemeal, and inefficient manner.

It is inefficient, because it does nothing to deal with the underlying problem facing Greece, and facing other EU countries themselves such as Portugal and Spain, but also to a considerable degree even larger economies such as the UK. That is the basic issue of a lack of sufficient, globally competitive, industries to enable them to pay their way in the world, whilst maintaining existing living standards. Greece is just the most stark example of that problem facing much of the EU. Ireland, in fact, does not have that problem to such an extent. In the last few decades, Ireland has been able to restructure a lot of its economy, pulling in many global high-tech companies, and that provided the basis for many Irish people repatriating, which in turn stimulated its housing boom.

Ireland's real problem was that it used the access to cheap credit to finance that housing boom, which also financed rapidly rising property prices, and credit fuelled consumption. If Ireland's debt burden, built up as a result of that, was scrapped, and consequently, if the massive austerity measures, introduced to pay for it, and which are crippling the economies potential for growth, were no longer necessary, then Ireland could begin to grow sustainably pretty quickly.

But, that is not the case in Greece. It is not the case in Portugal, and it is largely not the case in Spain and Italy. The current bail-out, therefore, does nothing to deal with the underlying problem in Greece, of a structural deficit of around €15 billion a year. Even if all of the Greek debt, currently estimated at around €340 billion, were wiped clean, there would still be this €15 billion to deal with. Ultimately, that can only be dealt with, if Greece were to restructure its economy so that it developed new industries and sources of income that were able to compete globally. The only other solution to that, would be for a large reduction in Greek living standards, but that would have further complications in that it would mean a reduction in the quality, of Greek Labour Power, making it even less competitive, and would also mean that in the short term, Greek Capital itself would find it harder to realise Surplus Value, due to a reduction in workers consumption, and that would make accumulation even harder.

The real solution then lies in restructuring, and that is a lengthy process requiring at least ten years. So, in addition to wiping clean the €340 billion of debt, to which has to be added that now owed as a result of the bail-outs, amounting to perhaps another €200 billion, it would be necessary to finance that on going annual deficit of €15 billion for up to 10 years i.e. a further €150 billion. But, even that would basically only maintain the status quo. For restructuring, large amounts of additional investment are required, which could only under current conditions be provided externally. I estimate that for an effective restructuring something around 10% of GDP p.a. would need to be set aside for investment to bring about such a restructuring.

Some of that would need to go to Public sector investment in schools, education, training and so on; some would need to go to rebuilding infrastructure, and creating an infrastructure fit for the 21st century, such as the laying down of high speed broadband, or the creation of an efficient wi-fi network providing high speed broadband access; some would need to go to recapitalise Greek Banks, which would probably have to be nationalised as part of such a process; and some would need to go into creating new industries where Greece could be competitive. Most of the latter would probably come from private sector investment, but that will only materialise if companies and investors believe that the economy is basically sound and underwritten. Assuming half of this investment came from the private sector, it means that Public investment would need to be around €10 billion p.a. for 10 years, or a further €100 billion. That means the total cost to the Eurozone of solving the Greek situation would be around €750 billion over ten years.

That is not at all impossible to achieve, but it is way above the current amount available in the EFSF and EFSM mechanisms created to deal with such bail-outs. Moreover, that is just to deal with the fairly minor economy of Greece. When we come to look at the issue of a similar resolution of the problems of Portugal, and more specifically, Spain, Italy, Belgium and others, then the figures become considerably larger.

It can be seen why what is required is being described as some form of Marshall Plan, and it can be seen why what is required to pay for it, is not some tinkering about with a few billion here and there, or short term financing by the ECB, but is the establishment of some form of fiscal union, and the issuing of EU Bonds. That is why even the Tories are now saying that Europe should proceed with further integration, a development which when it occurs, will pose problems for a still Eurosceptic party, which heads a country that will find itself increasingly excluded from the important decision making within such a European state.