Yesterday, $28 billion was wiped from the value of Australian share values. With the economy growing strongly and many firms embarking on huge expansions, why are shares falling?
The answer is Greek debt. The hugely indebted Mediterranean nation is struggling to pay back the interest on its massive foreign loans, and is currently negotiating bridging finance with European and international institutions such as the European Union and the International Monetary Fund.
Greece’s public finances are in ruins. The country has lived well beyond its means for a generation, financing generous pensions and public sector employment programs — not to mention the 2004 Olympics — largely by bond issues to the international debt markets. The situation would be serious even if Greek citizens and companies paid all their taxes. But tax avoidance is endemic, so the country’s true levels of internal revenue have consistently been lower than government expectations.
Greece’s crisis is now several years old. The nation negotiated a €110 billion bailout with the European Union and the IMF in May last year. The bailout included stringent conditions forcing the Greek government of George Papandreou from Greece’s centre-left PASOK party to take savage austerity measures, including stiff tax rises and huge cuts to pensions and pay for public servants. Unsurprisingly, the Greek economy has continued to struggle, further exacerbating the country’s fiscal woes. Now the government needs a second — or third, depending on how you define it — bailout if it is to avoid default on its vast bond issues.
Greece’s problems are not entirely self-inflicted. The country is also paying a terrible price for the denomination of its debt in Euros, which prevents the country from devaluing its currency. As a result, Greece’s exports, which represent its best chance of growing its way out of trouble, are far too expensive to be internationally competitive.
The story of Greece’s sovereign debt problems is really the story of the failure of the European monetary union, which is fundamentally failing the citizens of its poorer periphery countries.
Historically, there are only three ways out of sovereign debt crises of the magnitude faced by Greece (and Portugal, and Ireland). The first — and by far the best — option is economic growth. Strong growth would eventually start to replenish Greek tax revenues, allowing debt to be slowly repaid.
But the huge cuts to public sector spending required as a condition of Greece’s bailout have crimped Greek growth. Weaker government spending has largely cancelled out the gains by Greece’s private sector in the famous "paradox of thrift" identified by Keynes two generations ago. Indeed, you don’t have to be Keynes to realise that tax hikes and savage pay cuts affecting a big section of the population will have negative impacts on economic growth. As might have been predicted, unemployment rose sharply in the wake of the austerity measures.
The second escape hatch for indebted nations has generally been currency devaluation and inflation. For debt issued in a country’s own currency, devaluation can make debts easier to pay, effectively imposing a haircut on overseas creditors. Devaluation also has the added effect of making imports more expensive and exports cheaper, potentially creating the conditions for an export-led recovery. Inflation is a similar strategy. Printing more money to pay back creditors is a time-honoured strategy for banana republics, even if the result is often economically devastating.
Unfortunately, Greece can’t do this. Its currency is the Euro, which means that every unit of currency it pays back to foreign creditors has to be found from somewhere inside its own economy. Nor can the country devalue its currency to stimulate export-led growth, such as tourism. This is why the austerity measures have cut so deeply and been so unpopular.
The third escape hatch is default — in effect, to declare national bankruptcy. Default means a country simply refuses to pay back some or all of its debt and starts afresh, generally with a new currency to boot. For a sovereign nation, default is often the final result of unsustainable borrowing — most notoriously for Argentina, which has defaulted regularly in its history.
A Greek default is of course the source of the fear stalking global markets. Should Greece decide not to pay back all its debts, many European banks will be landed with huge losses, further weakening Europe’s already fragile economic situation.
But some form of default, or at least debt modification, looks increasingly likely, as the Greek political situation spirals further downwards. There have been three general strikes in recent months and the PASOK government is struggling to retain the support of the Greek parliament. Overnight, Athens was again the scene of mass protests as Prime Minister Papandreou reshuffled his cabinet and attempted to cobble together enough numbers to pass yet more budget cuts. The budget cuts have been required of Panadreou’s government by the IMF, which is threatening to withhold a €12 billion payment that Greece needs next month simply to keep the lights on.
Hard-headed observers now agree that some form of Greek default is almost inevitable. Former US central banker Alan Greenspan was quoted in an interview overnight as saying that "The chances of Greece not defaulting are very small" and economist Nouriel Roubini, famous for predicting the global financial crisis, has been predicting a Greek default and the subsequent break-up of the Eurozone for some time.
The potential contagion effects of a Greek default are unknown. Many fear a Lehman Brothers-like moment in which the disorderly bankruptcy of a big institution leads to the seizing up of global credit markets. That scenario is unlikely to play out in the short term, with the IMF and the EU determined to keep the money flowing to Greece, whatever the cost. They know that once Greece tumbles, other dominos — especially Portugal — may quickly follow.
In the medium term, however, the risks of a disorderly conclusion to the Greek sovereign debt crisis are growing. Austerity is already unpopular in all the countries where it is being imposed — even in Britain, where the conservative government has won surprising support from voters for its determination to tackle Britain’s public debt. That’s not unreasonable, as in the short term, austerity makes the economy and the fiscal crisis worse. Meanwhile, voters in Germany are turning against the Eurozone because of the responsibility it imposes on German banks and taxpayers to support profligate southern member nations.
Ultimately, a Eurozone currency union made up of large, economically advanced nations such as Germany, France and the UK, as well as small and economically disadvantaged nations like Portugal, Greece and Ireland becomes less and less sustainable every month. That situation seems inherently unstable and seems to imply some kind of break-up of the Eurozone — perhaps sooner rather than later.
What effects that may exert on Australia are unknown — but considering Australia’s vulnerability to external credit shocks (our big banks still source significant amounts of their day-to-day funding from overseas capital markets), the potential for economic collateral damage in Australia cannot be discounted.
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