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'Greece is like Bear Stearns. But there's a few Lehmans out there.'

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With markets tanking yesterday in part on fears over Greece's economic state and people starting to utter the words "financial crisis" again, I called Desmond Lachman to get an overview of the situation. Lachman is a resident fellow at the American Enterprise Institute. Previously, he served as a managing director and chief emerging market economic strategist at Salomon Smith Barney, and as a deputy director in the International Monetary Fund's Policy Development and Review Department. A lightly edited transcript of our conversation follows.

Ezra Klein: What has happened to Greece? We've gone from rarely hearing about them, to occasionally hearing about them, to being told the global financial system is threatened by them. But they're tiny! How is this happening?

Desmond Lachman: The market has figured out that Greece is insolvent. They really can't address their budget deficit by the amount that the IMF is asking them to do without sinking their economy. That means the market is realizing Greece can't repay the $400 billion of sovereign debt they've got.

And then the bigger problem is that the markets are looking at Portugal and Spain and Ireland and the concern is that the European banking system is vulnerable to these crises because the European banks own these bonds. Spain has a trillion in bonds, and when you add Portugal and Greece and Ireland, you're talking $2 trillion. If there's a default on that, these bonds are in French, German and Dutch banks. So it's not just think rinky-dinky little economy, you're talking about the whole European banking system. Greece is like Bear Stearns. But there's a few Lehmans out there. And the question is, what happens if they come unstuck?

EK: Let me back you up even before the market's reaction to the IMF and E.U.'s bailout proposal. How did Greece get here?

DL: It's October of 2009. The new prime minister is elected and the first thing he does is say he's looked through the books and the budget deficit that seemed to be 6.5 percent of GDP was actually more than 12 percent of GDP. And the Europeans already had a limit of 3 percent of GDP to be in the E.U. So what was going on? First, the Greeks were lying. Second, now people begin to wonder if you can be in the E.U. with such a high deficit.

So then people began focusing on Greece's debt and realized that Greece looks like a Ponzi scheme. The government is just borrowing money to repay interest on their debt. And then people realized how bad Greece's finances were. Then people didn't want to lend money to Greece, and so Greece couldn't pay its debts, and that's how the crisis started.

EK: Let's talk about Spain and Portugal and Ireland then. Why has Greece led to concerns about other countries in stronger financial positions?

DL: Spain, Portugal and Ireland are not in as bad a position as Greece. But they've got similarities. Big budget deficits. To just look at Spain, they've lost a huge amount of competitiveness. They've got huge trade imbalances. Their external debt as a relationship to GDP is 135 percent. So that means both the Spanish government and the Spanish private sector have been borrowing like crazy abroad. They also had a huge housing boom that went bust, so they're in recession, and they've got a budget deficit at 11 percent of GDP. And the final point I'd make on all of this is that when Greece got bailed out, the German public went ballistic. Angela Merkel might have been able to do the Greek bailout, but the electorate is sending her a very clear message.

EK: And what a country like Greece would normally want to do is devalue its currency to boost its exports and grow their way out of the debt. But because it's in the euro, it can't?

DL: That is the issue. You've got huge budget deficits that you're now having to make huge cuts to deal with. When you do that, it depresses your economy. Generally when a country does this sort of fiscal adjustment, they devalue their currency to boost exports in order to offset the depressive impact on the economy from the budget tightening. But Greece doesn't have its own currency that it can control. So it's been asked to cut its deficit from 14 percent to 3 percent in the next three years. That will create a depression for them, which will mean less tax revenue, and less ability to pay off debt. The numbers just don't add up.

EK: So what can Greece do?

DL: The endgame for Greece is not good. They're going to have to restructure their debt to make it more bearable. That means going to the creditors and saying we can't pay you 100 percent on the dollar, we're paying 50 percent on the dollar. They might also have to leave the euro to be more competitive. And the reason this is a big deal is there's hundreds of billions of debt sitting on Europe's banking sheets. And that's why the Europeans are trying to bail out Greece.

EK: How does this hurt America?

DL: You've got interconnected markets. If the European economy is in deep trouble, people won't want to take risks. So they'll sell off risky assets everywhere, including the United States. Then the dollar will strengthen because everyone wants to get out of the euro. And that'll make our exports to Europe less competitive.

EK: I've heard a lot of criticism of how Merkel is handling this crisis. How much of the issue here is that we're seeing the weakness of an economic union without internal cultural solidarity?

DL: I don't buy that. They can't bail out all the countries indefinitely. Germany can solve this problem if it decides to write Greece a check forever, but they don't want that. They feel the Greek's didn't play by the rules and now they're expecting to be lent to indefinitely. Merkel may not have handled this perfectly, but she had domestic political constraints, and the more important point is the Greeks have been totally irresponsible. Merkel is a bit player.

EK: So what can the Europeans do? How do they stop this from tearing apart the euro?

DL: What the officials can do is slow the process down by having the IMF or European Central Bank buy Greece's bonds. But they're not solving the underlying problem which is that these countries have too much debt, they've lost competitiveness and they're stuck in the euro. At the end of this, either they'll need to write down the debt or get out of the euro. So if I'm a policymaker, what I want to do is kick the can forward so we can have the crisis at a more convenient time. But what has to happen is you have to have the debt restructured and these countries have to get out of the euro. Until that occurs, these countries have very gloomy prospects ahead of them.

Photo credit: Jin Lee/Bloomberg News

By Ezra Klein  |  May 7, 2010; 1:55 PM ET
Categories:  Interviews  
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Comments

If Greece ends up being forced out of the Euro, then there will be no Euro because it will have exposed the basic flaw in the whole Euro scheme -- that you can't have a stable currency union without fiscal and monetary union.

Posted by: greenmountainboy | May 7, 2010 2:21 PM | Report abuse

I'm concerned about trade - how will Europe handle intra-European current account deficits/surpluses? If Greece needs to bail on the Euro partly to help its trade competitiveness, does that signify a larger issue within the EU? Or am I making too much of this?

Posted by: jduptonma | May 7, 2010 2:27 PM | Report abuse

Judiciously ignored in this article is our own self-destructive Ponzi scheme that will bring the US to its knees and (in about 20 years) make us the property of China: Social Security (with plenty of help from Medicare, Medicaid, and a federal government whose spinelessness and ineffectiveness lead to $1 trillion+ annual deficits ad infinitum.)

Best buy that cabin in northern Canada and start stocking it.

Posted by: mr_bill_10 | May 7, 2010 2:41 PM | Report abuse

To clarify, I think the 3% of GDP deficit limit is for membership in the euro, and not the EU. In any case, most members have ignored that limit so its not as if its binding.

@Greenmountainboy,

You can have a single currency without fiscal union. A century ago, many nations of the world had the same currency - gold. The Americans called their currency the dollar and the Brits sterling, but since both were defined as a unit of gold, each essentially had gold as the national currency. Not everyone liked all that came with it (as today, it is hard to run significant budget deficits when you can't print the currency to pay your debts), but it worked for decades and only fell apart due to WWI.

Posted by: justin84 | May 7, 2010 2:45 PM | Report abuse

Mr_Bill_10 above is optimistic with his "in about 20 years" comment.

Posted by: rmgregory | May 7, 2010 2:47 PM | Report abuse

"The new prime minister is elected and the first thing he does is say he's looked through the books and the budget deficit that seemed to be 6.5 percent of GDP was actually more than 12 percent of GDP. And the Europeans already had a limit of 3 percent of GDP to be in the E.U. So what was going on? First, the Greeks were lying."

It seems bizarre that in this day and age it is possible that a European government could distort the ratio of debt to GDP by this much. I can only conclude that the ECB and the banks that lent the money are woefully inept, if they could not independently pick up on the fact that the numbers were so far off.

Posted by: Patrick_M | May 7, 2010 3:04 PM | Report abuse

The underlying problem is that we are in a global economy that is contracting or at least adjusting to much slower growth. That leaves the weaker parts of the economy with particularly difficult adjustments. It also leaves the banking system with a large amount of bad debt. Like US real estate, the Southern European countries have particularly difficult problems. There is not likely to be any quick solution that will make them go away.

Posted by: dnjake | May 7, 2010 3:22 PM | Report abuse

"Judiciously ignored in this article is our own self-destructive Ponzi scheme that will bring the US to its knees and (in about 20 years) make us the property of China: Social Security (with plenty of help from Medicare, Medicaid, and a federal government whose spinelessness and ineffectiveness lead to $1 trillion+ annual deficits ad infinitum.)"


mr_bill_10 & rmgregory,


Judiciously ignored in these comments are the fact that there is a broad consensus that one of the reasons that the Greece engaged in excessive borrowing was lax tax collection at home.

Judiciously ignored in these comments is the fact that a huge part of our own deficit spending is the direct result of undue tax cutting by George W. Bush, coupled with unfunded endless wars overseas.

Your doomsday scenario judiciously ignores the fact that just ten years ago this country had a budget surplus. The supposed terrible crisis on the horizon in Social Security and Medicare is actually easily addressed by adjusting the tax contributions to these programs for people at the upper end of the income scale, who continue to pay dramatically lower taxes than they did in the Reagan era, and exceptionally lower taxes than they did during the Eisenhower years.

The benefits of America's entitlement programs are exceptionally modest when measured against those in other industrialized nations. The primary lesson from Greece is that as we emerge from the recession, we need the will to collect fair taxation on the wealth in our society in order to support what we spend, and not that we need to pull away the entire safety net from under our people.

Posted by: Patrick_M | May 7, 2010 4:13 PM | Report abuse

rmgregory and mrbill,

sadly, I told you so won't feel good.

Posted by: visionbrkr | May 7, 2010 4:13 PM | Report abuse

Patrick,

I disagree. What we need to do is BOTH be aware of our need for prudent tax collection AND we need to make sure the safety net while important does not become overburdened as it has in many states already.

Posted by: visionbrkr | May 7, 2010 4:17 PM | Report abuse

I second Patrick_M's comments to the hilt. The amount of taxes the upper 10% of this country pay has fallen dramatically since the Regan era. The republicans are the worst - they spent more and taxed less - resulting in huge budge deficits. Wake up America! Goldman Sachs and the republicans are turning America into an oligarchy. The elite's biggest fear is one-man-one-vote.

Posted by: kschur1 | May 7, 2010 4:37 PM | Report abuse

Bail out black mail, 2010 version.

In 1960 10% of U.S. investments were managed by "professional" investment managers. By 2007, this percentage had risen to 76%.

That means most of the money on Wall Street is moved around by a few thousand people. They all operate under similar (although debatable) strategies such as option formulas (Black-Scholes) and the efficient market hypothesis. That means herd trading activity. That is what we experienced yesterday.

The movement of money into and out of markets created by technology has started the new “irrational” market crisis problems. These began to emerge with the Thailand currency crisis and the collapse of the British Pound. Add to that the rogue trader issues in Singapore, London, and Hong Kong.

Money has concentrated to the point that finance conglomerates, hedge funds, and sovereign wealth funds ARE the market. They dictate the market. So when you read “investors” you can translate that to a few big players are bullying governments into paying black mail. This problem will not be resolved until this concentration is broken up.

Posted by: NewThoughts | May 7, 2010 5:22 PM | Report abuse

"I disagree. What we need to do is BOTH be aware of our need for prudent tax collection AND we need to make sure the safety net while important does not become overburdened as it has in many states already."

visionbrkr,

Did I argue in favor of "overburdening?"

I think it is difficult to argue that Social Security is overburdened on the benefit side as much as it will become somewhat underfunded thanks to demographics. If anyone wants to argue that a retired person subsisting on a Social Security check and Medicare health benefits is living too grand a lifestyle, that's an argument I'll be glad to have.

If you think the system is over-burdened, I would be happy to consider a relatively high threshold for means testing the allowance of benefits under both programs. I don't think Bill Gates will need a Social Security check or medical benefits in his old age as badly as the people who mop the floors in his office will need that lifeline.

I just think it is ludicrous to seriously contend that America can't afford the baseline entitlement benefits our nation provides. Just raising the salary cap on which Social Security taxes are collected by a modest amount would ensure the solvency of that program.

~ Have a good weekend ~

Posted by: Patrick_M | May 7, 2010 7:08 PM | Report abuse

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