Tuesday, June 01, 2010

No Easy Choices for European Central Bank and the Greek Debt Crisis
Joe El Rady

Jean-Claude Trichet is the last person on earth I would want to be right now. Actually, maybe Jesse James is the last person that I would want to be right now. Regardless, Trichet and the European Central Bank possess no easy choices to contain the Greek debt crisis and its contagion.

Jean-Claude’s main problem (I’ll call him by his first name because, even though we don’t know each other, I think he’d like me and we’d be friends) lies in the fiscal nature of the Greek crisis. The credit crisis of 2007 and 2008 showcased the ECB’s competence precisely because it fell within the ECB’s competence and domain: financial stability and the banking system. A fiscal crisis in Greece, however, requires fiscal solutions, over which the ECB possess no power beyond reminding governments to impose austerity.

Meanwhile, an unsettling situation similar to the 2008 credit crunch has emerged in which mounting unease about the health of European economies and banks has tightened funding markets, increasing the cost of daily operations for many financial institutions. Interbank lending rates have spiked to levels unseen since mid-2009. Increasing Credit Default Swap rates for financial institutions and falling yields on German bunds have both evinced and exacerbated stress in the financial system.

Fears have intensified that Greece’s financial crisis could spread to countries such as Spain, Italy and Portugal. This has spurred banks in the UK and continental Europe to grow leery about lending to other banks, especially those heavily exposed to countries facing challenging fiscal situations. In addition, banks have been trying to unload sovereign debt from troubled Euro-zone countries, but have found little interest.

These funding pressures have provided the main non-fundamental reason for the recent slides in global equity markets. Funding strains force institutions to sell higher quality assets, but with fewer available buyers bid/ask spreads widen, desiccating liquidity and dislocating markets.

This sort of spreading financial market contagion has proven uncontainable. Just examine recent events. Once stocks started to fall, already weakened corporate bond risk and Credit Default Swaps premiums blew out, further evaporating credit market liquidity (which is what started the mess to begin with… see the cycle?)

These pressures force central banks to intervene. Of course, swap lines with the US Federal Reserve and other liquidity provisions can help ease the situation in the short term; however, these solutions also offer long term pain. Unlike the Fed and the Bank of England, whose quantitative-easing programs sought to avert deflation and push investors to buy risky assets, the ECB’s liquidity programs would simply monetize deficits that the market has declined to fund.

In Greece, the public sector comprises 40% or more of the work force, with short weeks, lots of vacation and lavish retirement benefits. All of that requires funding with real income, not debt, and the markets are anticipating the day of reckoning.

Obviously, debt restructurings in Greece and elsewhere provide the best solution. However, in the short term, this could create further banking turmoil. Given the situation, the Euro faces a very frightening future. Either outright defaults will occur and lots of Euros will be printed to replace the lost money supply; or, huge bailouts will occur and lots of Euros will be printed to pay for them.