It seems that the equity markets are shrugging off a rather tumultuous few weeks. The consensus is that the Greece situation is under control and the crisis mode has been put at bay. The credit spread (default probability) for Greece has fallen dramatically from a peak of about 430bps (30% 5 year default probability) to about 350bps (25% default probability). This is a large swing in a few days time, but actually par for the course as far as credit markets trade.
There are a few promising things that I have learned and the most useful is that the ECB has the capability of supporting Greece. The European Central Bank is not allowed to purchase government securities as soon as they are issued (thereby supporting the demand part of the equation) but they are able to buy European government bonds on the secondary market. What this means is that if Greece needs to raise money, then the ECB can purchase existing Greek bonds from banks and institutions so that when the new debt comes to market there is demand. Effectively this means that the ECB can monetize the debt issuances of European governments even though the ECB’s mandate is to target a 2% inflation rate and nothing else. The fact of the matter is that politics always over ride good decisions.
The Greece situation is a case study on multiple fronts. Europe is basically confronted with similar problems to what the United States was confronted with in 2008/2009. In the case of the United States, it was fairly easy to ascertain that financial backing of the banks would stem any catastrophic financial collapse. In subsidizing US banks, we were effectively subsidizing the loose credit and poor financial investments that have occurred within our borders. In the case of European banks, these are separate countries with separate governments. If the ECB supports German and French banks, then they are basically subsidizing a lack of financial responsibility within Greece. And if you give the “A-OK” to Greece, then what sort of moral hazard does that introduce into the rest of European countries that have “flipped the bird” to Eurozone policies?
I am going to watch this entire spectacle with a bit of bemusement. It is a dilemma that has never been confronted before and makes for fabulous economic discussion. I hope that the Eurozone is able to dig its way out of this problem, but I suspect that the Euro will head lower and the entire situation will hit crisis mode before it is ever resolved.