Neils Jensen: The European Disease

This article is a guest contribution by Neils Jensen, Absolute Return Partners.

“You cannot turn a pig’s ear into a silk purse, and there is no point in pretending that an economy like that of Greece could somehow become a mini-Germany ”with appropriate resolve and discipline”. And frankly, why should Greece wish to do so? From this standpoint, a mistake was made by admitting into the EMU certain nations who never should have joined the currency union in their current state. Greece was a salient example.”

Woody Brock

The last weekend in May took me to Reykjavik for the first time since the credit crisis brought down the Icelandic banking system and with it much of the local economy. I have always enjoyed visiting Iceland. It is a truly amazing country, offering a splendid mixture of fantastic scenery and unrestrained friendliness. You just want to come back for more; however, somehow I expected the crisis to have left deep scars. I am pleased to say that nothing could be further from the truth.

It made me think. How is it possible to be pushed to the very edge of the cliff only to bounce back so magnificently less than 24 months later? Does that hold the key to understanding what is happening to Greece at the moment and how we should expect events to unfold from here?

Prepare for the haircut

Let me begin by offering you this observation: Greece will almost certainly default before this crisis finally blows over, but it may take several more years before they run out of options. Furthermore, the default may be structured in a way that allows them to call it something different. But investors in Greek sovereign bonds will have to take a haircut whatever name they put on it.

The €750 billion rescue package presented a couple of weeks ago should be enough to keep Greece, Spain and Portugal afloat for a couple of years, but Germany’s willingness to underwrite the profligacy of other eurozone members will likely run out well before Greece can realistically turn the corner.

Here is the quandary facing Greece: The austerity plan which it has now committed itself to is quite simply incompatible with a return to decent GDP growth anytime soon, yet not severe enough to prevent public debt from continuing to escalate. And, according to the arithmetical logic of the situation, if the Greek economy doesn’t return to a growth rate of at least 5-6% per annum (equal to or higher than their cost of borrowing) relatively quickly, Greece will sink deeper and deeper into the quicksand.

In reality, in order to get the escalating debt under control, the Greeks will have to agree to much larger public sector cuts at a time when the local economy is flirting with deflation. As any economist will know, cutting debt in a deflationary environment is extraordinarily difficult; hence my conclusion that Greece will be forced to restructure its debt. The question is not if but when and, as usual, the Germans are in the driving seat.

Merkel has already seen the writing on the wall and needs to create a bogeyman. Her recent ban on short-selling was not so much an attempt to stabilise financial markets as it was a stab at creating a foe the German people can relate to – the speculator. She knows that more money will be required to keep Greece going, but she also realises that her countrymen’s patience with the situation will run out well before Greece is back on its feet.

Greece vs. Argentina

To the consternation of EU officials, comparisons have been made between the Greek crisis and that of Argentina in 2001. “Greece is not Argentina” they proclaim. Maybe not. But if the comparison is unfair, it is because, fiscally, Greece is actually in much worse shape than Argentina was prior to its default in 2001. Argentina's public debt was around 60% of GDP; Greece is hovering around 120%. Argentina’s budget deficit was 6.5% of GDP; Greece delivered a whopping 16% last year. Argentina’s current account deficit was less than 2% of GDP whereas that of Greece was over 11% of GDP in 2009. So the critics are right. Greece is not Argentina. It is actually worse.

Chart 1: How Much Debt Is too Much?

Source: Popular Delusions, Societe Generale Cross Asset Research, 6th May, 2010

So, how much debt is too much? Unfortunately, there is no simple answer. As you can see from chart 1 above, in the past, countries with less debt than Greece have defaulted. Meanwhile, other countries such as Japan, have survived perfectly well despite being burdened with much higher debt levels. It is very much a function of investor sentiment but also a function of who the creditors are. Countries which rely mostly on domestic investors to buy their debt should, all other things being equal, be less exposed. This certainly explains why Japan has managed relatively well despite extreme levels of debt. On the other hand, if the theory holds, countries such as Portugal and Ireland are now in a particularly vulnerable position (see chart 2).