Recipe for Greece

Despite the fact that Greece has already implemented radical austerity measures and despite the €45 billion secured from the EU and the IMF, the bond markets have continued to decent into insanity. The current 10-year yield spread between German and Greek 10-year bonds imply a 100% certainty of a 44% default (bond holders will get only 56% of the nominal value) assuming 0% risk of a German default. Anyone who studies historical defaults, not to mention the adverse consequences to Greece if it defaults should recognize that this is irrational.

But it appears that the bond markets are driven by speculators determined to implement a self-fulfilling prophecy, i.e. by short-selling they hope to drive up yields, something which they know will raise the assumed probability of default, and thus help raise yields further in a self-reinforcing vicious spiral.

How can this be solved? Since euro area exit and default are closed, and since further austerity measures would -at least alone- likely have no significant effect given current market sentiment, only one solution will be effective: namely for Germany and others to extend the 5% loan offer to indefinite amounts, coupled of course with tough demands to implement deficit reduction measures.

This would eliminate the risk of default, and would ultimately mean that Greek bond yields would fall to levels below 5%, thereby eliminating the need for the facility. Bond markets may not respond this way in the short term given the current irrationality, but it really wouldn’t matter since Greece wouldn’t have to borrow from them anyway. And since people in time would realize that this will be a obvious losing bet, yields would ultimately adjust.

But wouldn’t this be unfair to tax payers in Germany and elsewhere who has to „bail out” Greece? The answer to this is an emphatic no, because it wouldn’t really be a bailout since „bailout” traditionally means that the entity that bails out loses economically from it. But in this case it won’t. If Germany borrows €25 billion from the bond markets at 3% and lends that money to Greece, the German tax payers will gain 500 million euros per year. If the amount is €50 billion, the gain will be €1 billion per year, if the amount is €100 billion, the gain will be €2 billion per year, and so on. The German government (and other governments) will engage in arbitrage, not a bail out.

Since the mutual gain to both will be greater the greater the arbitraged sum, there is nothing unsustainable about this, regardless of how great the transactions will be.

Another key argument against this is that it might encourage other European governments to be fiscally reckless, because they expect to receive a similar deal.

This argument completely overlooks first of all that these loans comes associated with exactly the kind of fiscal austerity measures that the loans are allegedly discouraging and secondly that even with this help, Greece will pay a much heavier price than other countries with similar fiscal situations. At 5%, the real cost of borrowing will be much higher than for governments with similar deficits both inside and outside the euro zone. Greece is being more than sufficiently punished for its fiscal sins.

If EU leaders adopted this plan, the crisis would quickly fade away, relieving Europe’s economic problems. If they don’t, then anything could happen, and then ashes from Icelandic volcanoes might not be the only thing darkening the future economic picture in Europe.


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