Europe: a house of cards

EUROPEAN leaders have tried to characterise the October writedown of Greek debt as “private-sector involvement”. While the writedown would appear to be a default in all but name, efforts to maintain investor confidence have so far been surprisingly successful. Yesterday, US stocks and Asian stocks rallied amid optimism that European leaders are taking steps to deal with the crisis.

Excessive optimism is nothing new.

Recent history provides plenty of examples of people systematically over-estimating the likelihood of positive outcomes.  In 2000, the dot-com bubble pushed the NASDAQ above 5,000 (it currently sits at around 2,500).  In 2004, Moody’s held its credit rating for Greece steady after the country admitted that its budget deficit had exceeded the EU’s ceiling of 3% of GDP every year for 8 consecutive years (source: NYT).  In 2007, median house prices in the US hit an all time high based on a widely held belief that “house prices always go up”.

Optimism will buy European leaders some much needed time. But it is difficult to see how Europe will managed to quickly or painlessly repay combined public debts which stand at more than €9 trillion.  Europe’s enormous debts might be thought of not as a mountain but as a towering house of cards.  It was fairly easy to build but now appears almost impossible to deconstruct without knocking the whole thing over.

A house of cards is a fragile arrangement, it will collapse, not only under the burden of one card too many, but by mere want of carefulness.

Greek default in all but name

Whatever you say it is, it isn’t ~ Alfred Korzybski

IN OCTOBER 2011, private banks accepted a 50% writedown on Greek debt. European leaders negotiated the writedown to avoid a technical default.

It is surprising that ratings agencies did not classify the writedown as a default when you consider that S&P defines sovereign default as “the failure to meet interest or principal payments on the due date…contained in the original terms of the rated obligation when issued”.

In your author’s opinion, the writedown of Greek debt falls clearly within the S&P definition of sovereign default.

Undeterred however by rating agency definitions, European leaders have characterised the writedown as a voluntary “private-sector involvement” or PSI. This is clever politicking because a “private-sector involvement” sounds like a positive development. However, in reality, it means that private investors have lost 50% of their investment in Greek bonds.

European leaders are now using the same brand of financial wizardry which created the global financial crisis in the first place. Over the last few decades, countless risky financial products were sold to investors using harmless sounding terms like “credit default swap”, “mortgage backed security”, “special purpose vehicle” and “off-balance sheet financing”.

Characterising the writedown of Greek debt as “private sector involvement” is more of the same financial manipulation, but it is also shrewd politics. European leaders know that a Greek default could have devastating consequences for the Euro-zone.