Ignoring Greek moral hazard would have been cheaper, says Brandywine’s Francis Scotland
Germany and other AAA rated eurozone members could have bailed out Greece for as little as €200bn if they had acted quicker and ignored “moral hazard” principles, says Francis Scotland, director Global Macro Research at Brandywine, a subsidiary of Legg Mason.
Hindsight may be 20:20 but not so in the case of Europe. With hindsight most observers would say that it would have been a lot easier for the AAA rated countries in Europe, led by Germany, to guarantee all the sovereign debt and not worry about the moral hazard of bailing out Greece or Italy. The total cost would have been no more than €200 billion or 1.3% of GDP. Germany alone could have guaranteed all of this and boosted its debt-to-GDP ratio by only 5-6% of GDP. Even with Greece, Germany could have said that it will guarantee all existing debt but would not guarantee any new debt for countries with fiscal arithmetic that exceeds key thresholds. The free ride for Greece would have translated into instant appreciation in Greek bond prices and the prospect of self-stabilizing economic growth. That seems like a better outcome than borrowing to give Greece hundreds of billions of additional debt, the ECB buying Greek debt, the Bundesbank crediting Greece hundreds of billions through Europe’s internal bank transfer mechanism and investors participating in voluntary or involuntary haircuts anyway.
The European nations could still apply this same solution but now at much higher cost: guarantee all existing sovereign debt of Europe but not new debt. The impact on sovereign credit prices would be explosive. Banks would not have to retrench.
However, the German authorities have adopted the principle from the beginning that creditors should share in the loss on sovereign credit and each country is responsible for its own debt. As a result, what could have been a €200 billion loss could now turn out to be a multi-trillion euro hit to the euro-zone economy.
It is easy to be pessimistic. European economic policy in 2011 reads like a page out of the Great Depression: raise taxes, consolidate budgets, tighten monetary policy, worry about inflation when the real risk is a debt deflation, ignore the run taking place on sovereign bond markets and the banking system, and encourage even more credit contraction by imposing higher capital ratios. The scale of the contraction in bank lending is too big with no positive offsets. Europe’s approach to its challenges has destroyed the automatic stabilizers of economic growth. High quality Sovereign bond yields are supposed to fall during economic downturns and central bank initiatives are usually counter-cyclical which acts to weaken the currency. But European banks desperate to boost capital and liquidity hoarded capital and sold foreign-currency denominated assets in exchange for euro liquidity. Bank of England governor Mervyn King views it as potentially the most serious financial crisis we’ve seen, at least since the 1930s if not ever.