Thursday, July 23, 2015

Does Default on Greek Govt Bonds = Grexit?

I've long wondered why Greece needs to leave the Euro to default on its bonds.  It's obvious to everyone that it is a deadbeat.  Years of promises to the citizen's that they can work little, get a lot of government subsidies in their day to day lives, avoid paying taxes and retire early with plenty of money have ruined the finances of the Greek government.

So why not just let them default and let the capitalists/investors/speculators who bought Greek Government Bonds take the loss for betting on the deadbeat paying them back?

Well, economist John Cochrane explains that it can't happen - but it could have - by comparing the situation in Puerto Rico to that of Greece.

If the Greek banks didn't hold Greek Government debt as their primary reserves, then a default would have hit creditors in other places and woe to them.   Because the regulators of banks declare that Sovereign debt is risk-free it is commonly held as the safe investment of capital which provides the 'equity' portion of the banks' balance sheets.  Then suddenly it isn't safe.  In fact, it is in default, which erases the money.  Now the banks don't have a balance sheet that balances or a way to raise cash to provide to depositors.  They could turn to their central bank for a loan, but wait, that's the Greek Government.

So, if the banks were not in hock to the government, as Cochrane says 'loaded up' - for example, if they were all foreign owned banks regulated somewhere else with some other countries debt - then Greece defaults and on we all go.  

Regulators declare Government bonds, Sovereign debt, to be the best and safest asset because they believe it.  They are part of the Government.  This needs to change.

Walter Bagehot famously said, "An insolvent bank should be closed, its owners deprived of their investment, its assets taken over by better capitalized firms, its depositors made whole by the bank." - See more at economic principals.

Because they put their equity into Sovereign debt and the debtor defaulted, all the Greek banks are now insolvent, not illiquid.  Better capitalized firms are not available in Greece.

Maybe if all the Greek Banks were fire-sold to foreign banks, then Greece could organize a default.  It probably is still small enough that the foreign bankers might like to have the customers.  The default on the Government debt would now hit the IMF and the European Central Bank.   

It certainly could have worked this way if they had started to fix it when they entered the Euro.  Alas, all the European Governments have stood in the way of multinational banking to a greater or lesser extent and slowed the process of true European wide banks developing.

Accurate Reality:  Government debt is not a 100% risk free asset.  It should not be treated as such.  The Greeks got themselves into this.  They deserve some pain.  There might be a better way out than for the Greeks to have to pay back the world for 70 years of profligate spending in the next 10.  

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