When people talk about haircuts and Greece, they are no longer referring to the female beauticians that retired at 50 with a generous state pension because their work was “arduous.” Instead, they are discussing the losses, known on Wall Street as “haircuts,” that Greek bondholders might be force to take.
A WSJ column presents 3 default alternatives and 4 key issues.
- Selective default: Some bond payments are postponed while others are paid on time.
- Organized default: All bondholders take a “haircut” within a predetermined plan.
- Disorganized failure: All bondholders take a “haircut” but there is no predetermined structure.
- Greek financial obligations: Greece still is living beyond its means. If it defaults, how will it pay wages and provide public services?
- Greek banks: Greek’s banks own a lot of Greek bonds. A default would threaten Greece’s entire banking system. (This FT column is excellent.)
- European banks: Many euro zone banks that own Greek bonds have not yet recorded their true value on their balance sheets.
- Contagion: If Greece defaults, will investors, worried about risk, make borrowing much more expensive for Ireland, Portugal and other financially weaker euro zone countries?
Saying that Greece has been rather forthright about its dire financial straits, NY Times financial journalist Floyd Norris characterizes the lenders who own Greek bonds as the group that is avoiding reality. Their policy? “Delay and pray” or “Extend and pretend.”
Finally, an historical perspective from Harry Truman in 1947. “Should we fail to aid Greece and Turkey in this fateful hour, the effect will be far reaching to the West as well as the East. We must take immediate and resolute action.”
And long before 1947: The first of many times that Greece defaulted on her debt was during the 4th century B.C.
The Economic Lesson
A bond is an IOU, a promise to repay a loan. The value of the bonds Greece has promised to repay is close to 155% of its GDP. Because GDP represents the value of goods and services that the Greek economy produces during 1 year, comparing the 2 provides an idea of whether they are living beyond their means.
An Economic Question: The Greek government plays an active role in the economic life of its country through the salaries and entitlements it pays and the businesses it owns. Do you believe in considerable or minimal government economic intervention?
What are people saying about austerity, the 2010 word of the year?
According to Dr. Econ at the San Francisco Federal Reserve, households are demonstrating austerity by saving more and borrowing less. On the one hand, living within our means is good. But on the other, called the paradox of thrift, when everyone spends less, the economy tends to contract.
Characterized by small businesses borrowing less, banks lending less, and multinationals hiring abroad rather than at home, austerity helped businesses buoy profits. On the other hand, though, we need the Keynesian “animal spirits” that are starting to surface for economic growth and less joblessness.
Finally, just mention government borrowing and the word austerity pops up. Greece needs to cut back. Ireland needs to cut back. German austerity should be copied. As for the U.S., though, austerity was synonymous with debate. On the one hand, continuing to increase the deficit can mean unmanageable debt and future inflation. But on the other hand, cutting back too much, too soon, could reverse our economic recovery.
The Economic Lesson
Our last economic lesson of 2010 returns us to Harry Truman saying, “Give me a one-handed economist. All my economists say, “On the one hand…on the other…”
Let’s not look at CDOs, SIVs, ARMs, TIPs or ATMs. Nor do we need specifically to consider credit default swaps, securitization, hedge funds or venture capital. Instead, we can go to the question that Robert Litan asks at the end of his 47 page Brookings paper on financial regulation:
“What deserves preemptive screening?”
During the past century our government has decided which products need screening before entering the market and those that will receive regulatory oversight only after a problem is identified. Pharmaceutical innovation is the perfect example of prior approval. By contrast, car, train, and plane makers regularly implement progress without a regulator’s restraint. Only when they have a problem have government regulators intervened.The question we now face is how to regulate financial innovation? Before or after?
In his paper, Litan expresses concern that prior restraint of new financial products could retard the progress that has fueled GDP growth, created convenience, and facilitated monetary distribution. With cost/benefit analysis of an array of new financial products from the past three decades, he illustrates the good, the bad, and the so/so. Disagreeing with the Volcker Rule, Litan then asks if the cost will be too great if innovation is constrained by prior approval.
The Economic Lesson
For every decision, there are costs and benefits. Defining cost as sacrifice, economists encourage all of us to assess cost and benefit when making a decision–to say, ”On the one hand…but then on the other….” For that reason, Harry Truman once asked for a one-handed economist.