Friday, September 16, 2011

What will happen if Greece defaults?

You can be excused for thinking that Greece has already defaulted on its debts, causing panic in financial markets and mayhem in the streets of Europe. That might explain why European stocks are in a meltdown this year, with a lesser rout spreading to U.S. shares.

But the market turmoil of the last few weeks is merely a prelude to a Greek default. In reality, if Greece defaults, it probably won't be for a couple of months, at least. But markets now seem to think that a Greek default is inevitable, and the ramifications will be ugly. "Europe is going to go through a disastrous financial crisis on par with what occurred during 2008 in the United States," David Zervos of investing firm Jefferies wrote to clients recently. "It will be every man for himself in Europe as the problem degenerates." With that kind of outlook, it's no surprise that investors in European stocks--especially banks--are fleeing.

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The European debt crisis is undeniably complex and confusing--even to Europeans. The 17 nations that operate on the euro set up a bailout fund well over a year ago that was supposed to handle the financial crises in Greece, Ireland, Portugal, and other troubled states. Obviously it hasn't. Here's a simplified explanation for why: Greece needs more money than first expected, and may not be able to produce the deep spending cuts, tax hikes, and sales of public assets necessary to qualify for bailout money. Economic growth that's worse than forecast is making targets even harder to meet. With Greek citizens irate, the internal pressure to escape from brutal austerity measures may become overwhelming. If Greece caves, then the bailout payments would stop and Greece would run out of money, forcing it to default on billions in debt. Many taxpayers in Germany and other European nations would welcome that, since they're sick of sending money to spendthrift neighbors. But a Greek default would punish many of Europe's biggest banks, since they're the ones holding the debt. If Greece defaults, investors would fear the same thing from Ireland and Portugal and perhaps even from Italy and Spain. That's the meltdown scenario investors fear, and nobody's sure how bad it would get.

Europe's woes are similar to the U.S. subprime crisis that percolated for a couple of years, then erupted in 2008. Greece and other overindebted nations are like huge subprime borrowers who spent more than they could afford by racking up debt they now can't pay back. Like big U.S. banks during the housing boom, many European banks had shoddy underwriting standards and bought debt that was far riskier than they realized. A Greek default could be the European equivalent of the Lehman Brothers bankruptcy in 2008, which started a run on the whole U.S. financial system.

But there's a key difference between the United States in 2008 and Europe in 2011: American officials promptly came up with TARP, the Troubled Assets Relief Program, which allowed them to inject capital into banks that would have imploded without it. In Europe, it's far harder to devise a systemwide financial bailout, since there's no centralized fiscal authority comparable to the U.S. Congress or the Treasury Dept. So every bailout maneuver requires negotiations among 17 sets of politicians, each answerable to restive taxpayers and rival political parties in their home nations.

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In the summer of 2008, U.S. Treasury Secretary Henry Paulson famously quipped that he wanted a "bazooka" to help battle the looming financial meltdown. TARP, though unpopular, became Paulson's bazooka, while shock troops from the Federal Reserve marched right behind him and guarded the flanks with a their own extraordinary rescue measures. The European bailouts are now faltering because politicians there can't muster a bazooka. Instead of a huge, open-ended commitment to do whatever's necessary to save Greece and preserve the Eurozone, Europe has come up with piecemeal solutions meant to buy time and delay the day of reckoning. That's why edgy markets react wildly to small-bore pronouncements that might signal more or less political resolve, while grinding weekly declines signal that the markets are pricing in the steep costs that a worst-case scenario would impose on the European economy.

European politicians won't say so, but they're basically stalling for time as they wait for the enactment of a stronger, TARP-like bailout fund that would be able to cope with the ramifications of a Greek default. "An eventual Greek default seems certain," writes Mark Zandi of Moody's Analytics, "but European policymakers must provide enough financial aid to ensure that it happens after it is no longer a macroeconomic threat." Instead of the roughly $605 billion that's been pledged so far, he thinks it could take about $1.4 trillion. Meanwhile, investors are scrambling to protect themselves and gauge the impact of a European financial crisis. Here's a broad outline of that would happen if Greece defaults:

Government takeovers of European banks. French banks have the most exposure to Greece, and severe losses could basically force the French government to nationalize the banking sector, which has happened before. Shareholders would be wiped out by nationalization, which is why shares of big French banks like BNP Paribas and Societe General are down by more than 40 percent this year. If France did it, other nations probably would, too. "There would have to be a big bang approach," says Jacob Funk Kirkegaard of the Peterson Institute for International Economics. "It needs to be comprehensive, otherwise market uncertainty will shift from one country to another." Italy and Spain would almost certainly do the same as France, while Germany, with Europe's strongest economy, might be able to sustain its banking sector without government intervention.

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EuroTARP. Investors worry about a "chaotic" default scenario, but Kirkegaard says the whole thing would be scripted and most likely entail several steps. First, there would be a newer, more flexible bailout fund that European parliaments are likely to approve by the end of October. That would be the TARP equivalent, and it could be used to inject money into banks as well as to bail out specific countries. If bank bailouts happen, the European Central Bank might also go on a bond-buying spree similar to the Federal Reserve's "quantitative easing" programs that ran from 2009 through mid-2011. If it worked, that would stabilize the market for European sovereign debt and boost the value of stocks and other risky assets, just as the Fed's QE programs did for awhile in the United States. If Europe really got its act together, it would also announce a plan to create a unified fiscal authority able to issue "eurobonds" that would help all member nations raise funds, make tax policy, and exercise real fiscal authority over member nations. It would take years, maybe decades, to enact such a bureaucracy, but a credible plan to do so might reassure markets.

A smaller Eurozone. If Greece defaults, that would probably mean the end of its membership in the Eurozone. The drachma would return as Greece's currency, and Greece would set its own fiscal and monetary policy without having to answer to bailout masters in northern capitals. Of course, Greece would be out of money and unable to borrow, so its economy would get hammered. The drachma's value would be very low against other currencies, which would make Greek exports cheap and help reduce unemployment. But imported goods would become vastly more expensive. Martin Hutchinson of Reuters Breakingviews estimates that Greek living standards would decline by 30 percent or more. Great Depression-style bank holidays may be necessary, to prevent people from withdrawing all their money. Other debt-laden nations could follow Greece out of the Eurozone and take a chance on default, but the economic pain in Greece might also produce popular support for more thorough austerity measures meant to remain part of the club. Foreign tourists, it's worth noting, would benefit from default, since travel to Greece or any other nation kicked out of the Eurozone would suddenly become one of the world's great bargains.

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A fresh European recession. Measures needed to stabilize Europe's financial system would most likely curtail lending and other economic activity, as banks beefed up their capital reserves and dealt with writedowns. Several countries would also need to hike taxes and cut government spending, to cover losses caused by defaults. Many companies and even some countries would see their credit ratings downgraded, which would force them to pay more to borrow money. Europe is already on the verge of recession, and wider austerity measures would probably clinch another downturn.

A ripple in America. "Europe's problems pose a serious threat to the U.S. economy, but not necessarily a mortal one," says Zandi. Unlike their French and German counterparts, U.S. banks own only a tiny portion of the debt issued by the most troubled European nations. American banks are also in much better shape generally than those in Europe, thanks to the aggressive action in 2008 and to the 2009 "stress tests" that forced many of them to raise more capital and strengthen their balance sheets. Big U.S. companies are also healthy, with strong profits, and few if any are dependent upon European banks. Still, a recession and financial crisis in Europe would weaken demand for American goods and services in one of the world's biggest markets, at a time when the U.S. economy is struggling, too.

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A stronger Europe, someday. Traders focused on the short term have a lot to worry about, but Kirkegaard argues that the mounting crisis in Europe may be the only way to create the stronger fiscal union needed to forestall or address the kinds of problems that are tearing Europe apart. "Reform is only politically feasible in the midst of a crisis," he says. "It's going to take quite a long time, but the odds are good that this crisis will not be wasted, and will in fact be used to solve long-term institutional problems in Europe." So if your investment horizon happens to be a decade out, Europe might just turn out to be a good bet.

Twitter: @rickjnewman

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