A Hardened Solution to Greek Debt Crisis

Late Thursday evening in Europe a hardened solution to the Greek debt crisis appears to have been worked out.  This solution is likely to bring to a close over 18 months of procrastination on the part of European leaders.

Compromise won the day as the head of the European Central Bank, Jean-Claude Trichet, German Chancellor, Angela Merkel, and French President Nicolas Sarkozy, all gave in on entrenched positions to craft a tough solution.  Merkel gave in and committed more of her country’s money to bailing out Greece.  Sarkozy backed off on his plan to tax private banks to pay for a bailout, a plan that was understandably unpopular throughout Europe.  Lastly, Trichet backed off on his insistence that the Greek government could not be allowed to default on its debts.

Analysis:

Here are the details…

• The total amount of the new Greek sovereign debt bailout deal is €109 billion ($157 billion).  In combination, the euro zone and the International Monetary Fund can lend these monies to Greece over the next three years at an interest rate of around 3.5%.  Additional monies may be lent to Greece from the private sector.
• The €109 billion expands, by a wide margin, the already extant €440 billion bailout fund created last year.
• Additionally, the €440 check book can now be used to purchase euro denominated bonds in the open (i.e. secondary) market, rather than just being lent to countries on the brink of collapse.  This flood of liquidity/bids into the bond market will provide a floor on the collapsing prices and rising yields of euro denominated bonds.  This feature will also discourage short sellers.
• Colossally high interest rates on bailout funds have been lowered significantly and there is now the ability to issue loans with maturities of up to 30 years.  This means that borrowers (read: Portugal, Ireland, Italy, Greece, Spain) have many years now to get their financial and gross domestic product (GDP) growth engine houses in order.
• Greece’s private sector lenders must accept new debt in exchange for their old debt.  The new debt is going to be at terms that are much less favorable than what the bondholders held before.  Technically, this is a default on the outstanding debts.  This is also a first in the euro zone: a member has broken the promise to repay money it borrowed.  Ouch!  Yet, this is a good ouch.
• Other countries surviving on the largesse of their European neighbors can now renegotiate the interest rates on their borrowings.  For example, Ireland has complained loudly about their high interest rate.  Yet, France, which has always felt Ireland’s very low corporate tax rate was uncompetitive refused to grant a lower interest rate.  France has now dropped its demand that Ireland raise its corporate taxes.

What in this deal is important?

First, that I can finally communicate details of a plan to my loyal readers is an indication European leaders finally are serious about solving this problem.  Instead of a token gesture of support to Greece and then a promise to deal with the heavy issues at some point in the future, Europe finally got real.  This is a very good sign.

As I have written about, the economy of Greece is only about 2% of the European economy, so this crisis was much more about an existential question: Is the EU and its euro zone for real and can we trust it as investors?

Second, the deal shows that Europeans can compromise to save their own necks.  Germany, in particular, had the most to lose.  If the euro failed a reinstated Deutsche mark would rapidly appreciate relative to other European currencies.  That would make German exports – its number one source of economic power – very expensive and likely crush the German economy, and to a degree well in excess of the cost of any bailout of Greece.

The compromise also shows France and Germany working together on a European problem for the first time in years.  Since Merkel came to power the Germans have been reasserting their right to an individual destiny separate from the EU’s creator, France.  That these two nations have worked together means that the EU is finally stronger today than it was yesterday.  In other words, it has demonstrated the ability to be a body politic when necessary.

Third, as I wrote about earlier there may now be a separate, private banking crisis in Europe if this deal leads to the Euro appreciating significantly.

Fourth, essentially the solution to this problem is to print euros and then pump them into the economy.  In other words, let’s use an inflationary policy to get rid of a problem created by too much (real estate) inflation.  This “we cannot face the pain” solution cannot continue indefinitely; which brings me to…

Fifth, I like that Greek private sector investors are having to eat losses on their investments.  Capitalism only works if there is not just the opportunity of return, but also the pain of loss.  Without risk of loss people have no vested interest in doing their research and in insisting that the people they lend to are of a good credit quality.  Duh!

Sixth, will the financial markets of the world finally take the Europeans seriously?  If so, then the picture for the planetary economic recovery looks much brighter.  This is especially true since the U.S. debt crisis looks to soon be resolved.

Removing the twin debt crises from the collective consciousness of the investment community leaves only two remaining problems.  One, the U.S. unemployment situation; and two, the runaway Chinese inflation.  In all likelihood this European debt deal, and an impending U.S. debt deal, will give a boost to financial markets.

Now investors can put their attention on real investor-like things; things like: corporate profitability!  Also, U.S. consumers, rightly or wrongly, think of the stock markets as a daily evaluation of the quality of the U.S. economy.  If the financial markets go up then consumer confidence will go up.  Then will follow consumer spending and strengthening economic foundations.

But this is a lot of contingencies, so let’s not get ahead of ourselves and let’s just savor this moment.  Now to the next problem: if Europeans, who have savaged each other in wars throughout millenia, can agree to a debt deal to bailout countries completely unrelated to themselves then why can’t the U.S. political parties agree to a single nation’s debt deal?  Duh!

Importance grade: 9; enough said.

Jason

[This post was edited for flow, and only for content in a very minor way.]