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The Coming Greek Debt Bubble  By Peter Boone and Simon Johnson  Baseline Scenario

I think Johnson's arguments need to be considered in full, so I will quote him at length below.

Bubbles are back as a topic of serious discussion, as they were before the financial crisis.  The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?

Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit.  But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse.  A few investors can do well by betting against such bubbles, but it's harder than you might think because you have to get the timing right - and that's much more about luck than skill.

Bubbles are usually associated with runaway real estate prices (think Japan in the 1980s and the US more recently) or emerging market booms (parts of Asia in the 1990s and, some begin to argue, China today) or just the stock market gone mad (remember pets.com?)  But they are a much more general phenomenon - any time the actual market value for any asset diverges from a reasonable estimate of its "fundamental" value.


Perhaps Simon has seen a few bubbles while at the IMF. There certainly has been no recent shortage of cheap money, with "the world's reserve currency" being on offer at close to zero percent interest rates.

Bubbles are usually associated with runaway real estate prices (think Japan in the 1980s and the US more recently) or emerging market booms (parts of Asia in the 1990s and, some begin to argue, China today) or just the stock market gone mad (remember pets.com?)  But they are a much more general phenomenon - any time the actual market value for any asset diverges from a reasonable estimate of its "fundamental" value.

To think about this more specifically, consider the case of Greece today.  It might seem odd to suggest there is a bubble in a country so evidently under financial pressure - and working hard to stave off collapse with the help of its neighbors - but the important thing about bubbles is: Don't listen to the "market color" (otherwise known as ex post rationalization), just look at the numbers.

By the end of 2011 Greece's debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time - for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently).  About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany.  Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.

What if Greek interest rates rise to, say, 10% - a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called "austerity" program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe?  Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).

This is simply impossible and unheard of for any long period of history.  German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings).  Neither of these were good experiences.

We are not dealing with questions of definitive proof here. The issue is the risks and duties of public officials dealing with financial problems.  The meat of Johnson's argument is below.  

On top of all this Greece's debt, even under the IMF's mild assumptions, is on a non-convergent path even with the perceived "austerity" measures.  Bubble math is easy.  Hide all the names and just look at the numbers.  If debt looks like it will explode as a percent of GDP, then a spectacular collapse is in the cards.

Seen in this comparative perspective, Greece is bankrupt today without a great deal more European assistance or without a much more drastic austerity program. Probably they need both.

Given there's a definite bubble in Greek debt, should we expect European politicians to help deflate this gradually?  Definitely not - in fact, it is their misleading statements, supported in recent days (astonishingly) by the head of the International Monetary Fund, that keep the debt bubble going and set us all up for a greater crash later.

The French and Germans are apparently actually encouraging banks, pension funds, and individuals to buy these bonds - despite the fact senior politicians must surely know this is a Ponzi scheme, i.e., people can get out of Greek bonds only to the extent that new investors come in.  At best, this does nothing more than postpone the crisis - in the business, it is known as "kicking the can down the road."  At worst, it encourages less informed people (including perhaps pension funds) to buy bonds as smarter people (and big banks, surely) take the opportunity to exit.

While the French and German leadership makes a great spectacle of wanting to end speculation, in fact they are instead encouraging it.  The hypocrisy is horrifying - Mr. Sarkozy and Ms. Merkel are helping realistic speculators make money on the backs of those who take seriously misleading statements by European politicians.  This is irresponsible.

While Mr. Sarkozy, Ms. Merkel and Dominique Strass-Kahn may be possessed of iron resolve that Greece will not be allowed to default, the specifics as to what will be done have been scant. The article does say, rather vaguely, that "the French and Germans are apparently actually encouraging banks, pension funds, and individuals to buy these bonds..." and elsewhere refers to Sarkozy and Merkel by name and Dominique Strauss-Kahn by his position. (My italics.)

I can see two sides to this issue. With most of the bonds held by French and German citizens or institutions neither Sarkozy nor Merkel want to precipitate a default and must take care not to do so.  But if they give the impression that a default will not be allowed to happen without having in place the means to prevent default and if any in their governments encourage institutions or individuals to purchase these bonds, their position in the event of a default will be questionable.

I have read of non-specific plans to provide French and German support for Greek debt and Greece has just issued new bonds--after the question of possible default has arisen. And I recall that the sale of these bonds to Europeans has been favorably characterized in press reports. Unfortunately, I had not seen the arguments put forth by Johnson and Boone when I saw these reports, so I did not bookmark them. But if Johnson and Boone are correct in their analysis and Greece is caught in a debt trap there will be plenty of time and reporters to sift through public statements by all involved. Meanwhile Johnson and Boone are apparently being circumspect by implying more than they can demonstrate. Time will tell who is better serving potential purchasers of Greek debt.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 12th, 2010 at 12:12:52 AM EST
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