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