Global growth is clearly fading. China may slow to under 8% this year, as exports are being hit sharply by slowdowns abroad. Japan’s eternal trade surplus faded and fell to a deficit last quarter for the first time in decades. Europe’s economy evidently shrank in the fourth quarter of 2011. And yesterday we learned that the US economy, which had seemed primed for growth in the last quarter, turned in a lackluster 2.8% annual rate of increase for that quarter as well. That would not be bad if it augered a steady 3% growth rate going forward; but given the overall performance it tallies up to a U.S. growth rate for 2011 of about 1.5% overall. As Rogoff and Reinhart have argued, we will not see a return to robust growth until the bad debts and toxic assets hanging over the world’s economies are worked off or written down. Iceland and the U.S. have made some progress on this, but most of the world’s economies are actually still increasing their debts, hoping to avoid paying the piper.
And then there’s Greece. Will it default? Even Angela Merkel admitted that, given the poor performance, indeed the ongoing contraction, of Greece’s economy, it will not be able to repay its current debts even with outside help. The Greek economy appears to have shrunk by 6% in 2011, and is forecast to do almost the same this year. Under that scenario, its debt burden will not fall to acceptable levels in the next decade. So what will default look like?
To paraphrase from another political dilemma, that depends on what the meaning of “default” is. After a year of heavy bond purchases, most of Greece’s debt is now held by the European Central Bank. Much of the rest is held by hedge funds and other private banks. The latter are being asked to accept a ‘voluntary’ reduction in what Greece owes them. The supposed thinking behind this is: (1) in a voluntary reduction private bond holders will still get more than if Greece defaults, so for them something is better than nothing, and (2) if Greece avoids a formal default by making a voluntary deal with some of its creditors, the bonds held by the ECB will keep their nominal value, allowing the ECB to avoid a costly write-off that would undermine its ability to back the Euro.
Unfortunately, the incentives for the private bond holders only make sense if they are asked to accept a modest reduction. The reason for this is that private bond-holders have insurance (credit swaps or derivatives) that protects them and restore their capital if Greece formally defaults. So for the private bond holders, a deal that is too extreme is worse than no deal at all. The real unknown is how a default would affect the counter-parties who have written the credit swaps and promised to make good on a sovereign default that was initially deemed so unlikely as to be almost impossible (oh yes, like an across-the-country decline in house prices in the U.S.).
Yet Greece’s economy is in such bad shape that it doesn’t look like it can make good on a modest reduction; Greece is asking for more than a 70% cut in what bond-holders will get compared to what they were promised when they purchased the bonds. That actually makes default (which triggers their insurance coverage) attractive for them.
The world’s problem, though, is that a formal default on Greek bonds would be similar to what happened in the default in the market for sub-prime mortgages. Yes, the amount is quite small as a fraction of the overall debt market. But because these debts were supposedly risk-free and insured as such, a default on Greek debt would reset the expectation (and insurance obligations) regarding ALL sovereign debt. And since no one really knows how extensive or deep any particular financial entity is sunk into credit swaps on sovereign debt, no one can tell which institutions will emerge strong or weak. That means the rational response to a Greek debt default for financial institutions would not merely be to stop trading with Greece, but to stop trading with ANY other financial institutions altogether. This is exactly what happened with Lehman and why the sub-prime crisis brought the world financial system to a halt and launched the Great Recession. The run-on obligations related to Greek debt are interwoven throughout the fiscal system in a similar fashion.
So what will happen? As predicted by myself and others, the hope that “the growth fairy” would return, and provide enough security and means for Greece to repay a modestly renegotiated debt settlement, has proven false. Any settlement that comes now, after two more years of decay in the Greek economy, will be messy at best, dangerous at worst. Hang on; it will be a bumpy ride.