The First Domino?

Richard Parker, lecturer in public policy at Harvard Kennedy School writes in the Nation, Athens: The First Domino? (Hat Tip: Ken):

The shadow of classical Greece has always loomed large over Western civilization--whether in literature, philosophy, art, mathematics, history or politics, it has been, in so many ways, the fons et origo of us all. Modern Greece suddenly seems poised to play that same outsized role, but by no means in the same civilizing way. Athens's fiscal crisis could very well ignite the next global financial crisis--just as the world hoped it might be starting a slow exit from the last one.

After meeting with fellow European leaders in Brussels in early February, where he argued the case for help in solving the hefty budget deficit he'd inherited on taking office last fall, Prime Minister George Papandreou flew home to Athens to tell his countrymen that he'd returned with a half-full cup of promises--and no assurance of the serious backing Greece needs to weather its woes. Global markets, which had been fibrillating nervously for three months about Greece's (and the euro's) financial health, skipped several beats after Papandreou's speech, after already suffering a long sell-off that wiped out much of Wall Street's shaky recovery. All eyes are anxiously casting about for Delphic signs of what Europe's finance ministers will do when they meet to hear Greece make its case again, this time in hard numbers.

The situation has the makings of an Aeschylean tragedy. If help isn't forthcoming, little Greece--whose economy is just 3 percent of Europe's GDP--could, against its will, set off a chain reaction that pulls down Portugal, Ireland, Spain, perhaps even Italy, and thereby throws Europe's, and then America's and the rest of the world's, fragile recoveries into reverse.

The crisis is, in classic Greek fashion, ripe with ironies. Papandreou came to office in October determined to clean up his country's longstanding fiscal recklessness and widespread corruption. It was he who first exposed the scope of the dilemma immediately after discovering that this year's deficit would be double what his conservative predecessors had promised. Moreover, Papandreou has consistently insisted that his government will keep the promises it has made to Greek voters and to EU auditors to bring the deficit, now almost 13 percent of GDP, down to less than 9 percent this coming year and to the EU-mandated ceiling of just 3 percent within two more. But traders and speculators, sensing the size of the task the government faces, have forced interest rates on Greek bonds to record highs, betting that the country is close to default. (The traders' role is itself ripe with ironies because Goldman Sachs and other top Wall Street firms had earlier in the decade helped Greek governments move liabilities off state budgets by constructing the same sort of offshore entities and complex derivative swaps that were at the heart of the US banking system's collapse a year and a half ago. Revelations of the deals by the New York Times generated new attacks on the Papandreou government, despite the fact that it was his government that had exposed the dealings.)

The question, as one very anxious European banker told me, is "whether Greece will be the Bear Stearns of sovereign credit." Greece's outstanding debt is more than Bear Stearns's $400 billion balance sheet exposure in 2008, before its collapse--but there the analogy ends. Greece is a sovereign nation, not a company, and it isn't going bankrupt, not least because its currency is the euro, shared by 320 million Europeans and backed by an economy larger than America's. But if it is forced into debt rescheduling and renegotiation, Greece could well spark a panicky stampede.

What makes this crisis especially painful is not just that we've seen it happen before but that its solution is far less complicated. What Athens needs are the funds to service the gap between its revenue and its obligations, a net deficit that gets smaller each week as it carries out the painful cuts needed to bring its budget back to the EU's mandated standards. Public sector salaries, from the prime minister's on down, have been slashed; hiring has in effect been frozen; civil service retirement ages pushed up and benefits reduced; and social services and the military budget are being curtailed across the board. For Greeks it is an excruciating moment. Despite a nationwide strike called for later in February, opinion polls show the majority still favor Papandreou's painful choices.

Moreover, unlike Wall Street bankers, Papandreou isn't asking for a bailout (let alone a bonus for himself or senior ministers); what he wants is help stabilizing the market for Greece's bonds. And unlike Wall Street in the fall of 2008, Athens isn't being frozen out of the credit markets; in fact, it is still able to borrow. Its most recent 5 billion euro bond offering was actually oversubscribed by 20 billion, which allowed the government to increase the offering by a healthy 3 billion euros. Moreover, with unprecedentedly low global interest rates, Athens is paying 5 to 6.5 percent on medium-term bonds. That's not cheap, but it's far below what other small countries have paid in similar circumstances.

But Wall Street speculators have swarmed in, playing Greece, as the Financial Times put it, "like a piñata." The country's tiny bond market--barely a billion euros a day were trading in Athens in January--makes an easy and tempting target for traders with big bats; by attacking Greek bonds, the traders get to play on an increasingly pan-European volatility in bond and currency rates, thereby leveraging a little nation's problems into gigantic trading-floor gains. And thanks to the Obama administration's repeated refusal to limit such activities--despite pleas from our European allies since 2008 to jointly reregulate global financial markets--what the traders are doing is legal. In fact, massive immediate trading profits are the means by which banks like Goldman, Citi, JPMorgan, Barclays, UBS and Deutsche Bank are rebuilding their balance sheets without providing the lending the real economies of America and Europe need to begin their recovery.

Athens desperately needs the maneuvering room that visible European support would provide by driving off the speculators and letting Papandreou's government focus on domestic restructuring. That needn't cost wary German, Dutch or French governments and their taxpayers billions; to the contrary, Berlin, Amsterdam and Paris could snuff out, at quite low cost, the smoldering coals before the real fire breaks out, and with very little risk. Europe could, for example, put up no money and simply offer to guarantee Greek bonds, much as the FDIC raised its guarantees to US banks and then extended them to money market funds after Lehman collapsed in 2008. European governments--with deep pockets and long time horizons--could also help by buying some of the bonds and encouraging public and private banks to do likewise. The $15 billion in EU development funds Greece is eligible to receive could be expedited and expanded, with no new burden on Europe's taxpayers.

The price of not acting now is high--and not just for Greece. For Europe it means a fiscal and credit domino effect among weakened EU economies, driving borrowing costs even higher for the prudent and profligate alike. For America, a weakened euro--which has already fallen almost 10 percent against the dollar over the past three months--means a rising dollar. That, in turn, means a rising US trade deficit--not the best strategy for helping America escape its own crisis, let alone meet President Obama's dreamy goal of doubling US exports in the next five years.

The scale of what's happening has suddenly dawned on even the most conservative European skeptics. Ambrose Evans-Pritchard, the influential English financial columnist, stopped his long diatribe against Greece's fiscal policies and called for European aid. The Economist's Athens correspondent, who's been no less relentless, has also suddenly switched views, while the Financial Times, after excoriating the Papandreou government for not making cuts so deep they would guarantee a depression, suddenly has awakened to the dangerous game that traders are playing and the risks it poses for everyone.

With so many at last realizing just what Greeks bearing a bitter gift of sovereign default could ultimately do to us all, there's still reason to hope that we may not yet be facing Global Financial Crisis 2.0.

Reporting for the NYT, Nelson Schwartz and Graham Bowley write Traders Turn Attention to the Next Greece:

Even as Greece pledged anew on Wednesday to rein in its runaway budget deficit, briefly easing the anxiety over its perilous finances, traders on both sides of the Atlantic weighed the risks — and potential rewards — posed by the groaning debts of other European governments.

While investors welcomed news that Athens would raise taxes and cut spending by $6.5 billion this year, analysts warned the moves might not be enough to avert a bailout for Greece or to contain the crisis shaking Europe and its common currency, the euro.

Indeed, some banks and hedge funds have already begun to turn their attention to other indebted nations, particularly Portugal, Spain, Italy and, to a lesser degree, Ireland.

The role of such traders has become increasingly controversial in Europe and the United States. The Justice Department’s antitrust division is examining whether at least four hedge funds colluded on a bet against the euro last month.

“If the problems of Greece aren’t addressed now, there is a risk the market will focus on the next weakest link in the chain,” said Jim Caron, global head of interest rate strategy at Morgan Stanley.

Whatever the outcome in Athens, the debt crisis in Europe threatens to tip the financial, as well as political, balance of power across the Continent. With Germany and France emerging as the most likely rescuers, leaders in Berlin and Paris could end up dictating fiscal policy in Portugal, Ireland, Italy, Greece and Spain.

And in the months ahead, fears about the growing debt burden elsewhere in Europe are likely to return, according to investors and strategists. That is particularly worrying given that Western European countries must raise more than half a trillion dollars this year to refinance existing debts and cover their widening budget gaps.

The way fear can spread from capital to capital reminds Mr. Caron of how the American financial crisis played out. “What people are doing in the markets is no different from what they did with the banks,” he said. “First it was Bear Stearns, then it was Lehman Brothers and so on. That’s what people are worried about.”

France and Germany are emerging as the crucial backers of any lifeline for Greece, but they have slow growth and budget troubles of their own — deficits equaling 6.3 percent of gross domestic product in Germany and 7.5 percent in France. And among voters in both countries, “there is very little appetite for rescues,” said Marco Annunziata, chief economist for Unicredit.

The most vulnerable country after Greece, some analysts say, is Spain, which has been mired in a deep recession. Facing an unemployment rate of 20 percent, a budget gap of more than 10 percent of gross domestic product, and an economy expected to shrink by 0.4 percent this year, Madrid has little wiggle room if investors shun an expected 85 billion euros in new bond offerings this year.

Spain’s neighbor Portugal is also vulnerable. Large budget and trade deficits, combined with a shortage of domestic savings, leave Portugal dependent on foreign investors. And, as in Greece, there may be little political will to slash spending or raise taxes.

That’s in sharp contrast to Ireland, which had been a source of anxiety last year. New austerity measures, including a government hiring freeze and public sector wage cuts, have put it in a stronger position as it raises 19 billion euros this year.

The Italian government is also heavily indebted — it has more than $2 trillion in total exposure — but it is also in a slightly stronger position than Spain or Portugal because its economy is expected to grow by 0.9 percent this year and 1.0 percent next year. In addition, its budget is not as far out of whack, with the deficit this year expected to equal 5.4 percent of G.D.P.

According to Kenneth J. Heinz of Hedge Fund Research, the big hedge funds are now evaluating the response by other European countries in extending a lifeline to Greece before they probe weaknesses and opportunities in other countries.

Hedge funds, banks and other institutions are still wagering on a drop in the euro as well as the British pound.

Those trades have been controversial for months in Europe. But the debate shifted to the United States on Wednesday, after it emerged that at least four hedge funds had been asked by the Justice Department to turn over trading records and other documents. That request followed a dinner in New York last month where, among several other subjects, representatives of some of these hedge funds discussed betting against the euro.

The funds that received the letters — Greenlight Capital, SAC Capitol Advisors, Paulson & Company and Soros Fund Management — are among the best-known names in the hedge fund universe. Greenlight and SAC declined to comment, as did the Justice Department. Paulson & Company, whose representatives did not attend the dinner, also declined to comment.

In a statement, Michael Vachon, a spokesman for Soros Fund Management, denied any wrongdoing and said, “It has become commonplace to direct attention toward George Soros whenever currency markets are in the news.”

The dinner, in a private room at the Park Avenue Townhouse restaurant in Manhattan on Feb. 2, involved about 20 people and was characterized as an “ideas round table” by several who attended. But people present at the dinner or knowledgeable about the discussion said the idea of shorting the euro occupied only a few minutes of the conversation.

The presentation on the euro, by SAC, lasted less than five minutes, according to these people.

Notes provided by one of the firms that attended the dinner summarized the discussion on the euro state: “Greece is important but not that important; instead you have to start thinking about every other country. What’s after Greece? Spain, Ireland, Portugal.”

James S. Chanos, a hedge fund investor who has not been making bets on the euro, defended the positions taken by hedge funds, calling the inquiries into their activities “witch hunts.”

“Hedge funds and short-sellers are being blamed for the failings of other people,” he said. Nevertheless, the anxiety in Europe is reflected on the Chicago Mercantile Exchange, where trading in futures on the euro soared to a record $60 billion in February — up 71 percent from a year ago.

“The Greek story is putting downward pressure on the euro,” said Derek Sammann, a managing director at the CME. According to CME data, hedge funds are in their most bearish position in a decade in shorting the euro, said Mary Ann Bartels of Bank of America Merrill Lynch.

“They have been short for a while, but in the past two weeks have really pressed it,” she said.

Is Greece the first domino? Are hedge funds to blame from the euro's woes? How will sovereign debt defaults - if they materialize - impact the global financial system? There are no clear cut answers to these questions. Greece is not an economic powerhouse, but if you believe in the butterfly effect, then you don't want to risk seeing it go under. Hedge funds are not to blame for all market evils but they are not as benign as Mr. Chanos makes them out to be. The big funds often collude by "sharing ideas". A wave of sovereign defaults will surely cripple the global financial system, which remains very fragile following the last crisis.

And what about Greek pensioners? Just like millions of other pensioners and workers, they are exposed to the vagaries of the markets. For every Soros, Cohen, Griffin, Paulson there are millions of others living under the dark shadow of economic insecurity, just a step away from pension poverty. When the bigger dominoes start crumbling, who will bail out all of them?