Wednesday, May 12, 2010


Nice editorial by Gilbert at Bloomberg:

May 12 (Bloomberg) -- One of the proudest achievements of the euro project was ensuring government borrowing costs converged at the lower levels enjoyed by Germany rather than the higher yields paid by its less fiscally disciplined neighbors.

That’s over. Done. Finished. Just as the bailout of the banking system produced a plethora of unintended consequences, so the European Union’s decision to pledge almost $1 trillion to defend the single-currency project will unleash a series of undesirable aftershocks. Here are some that are inevitable.

It’s Solvency, Stupid, Not Liquidity.

Cast your mind back to March 17, 2008. Richard Fuld, then chief executive officer of Lehman Brothers Holdings Inc., said the Federal Reserve’s decision to expand the list of firms it lent money to “takes the liquidity issue off the table.” Six months later, Lehman was dead.

Europe can’t solve the problem of too much debt by adding yet more debt. Robbing Helmut to pay Stavros is a recipe for disaster. Giving Greece a helping hand over its bond repayment humps doesn’t fix the underlying crisis -- Greece is insolvent, and some of its peers aren’t in much better shape. That’s a far bigger worry for bondholders than any short-term cash-flow issues.

The Meanness of the Mean

Moral hazard, which came to the fore as governments admitted that some institutions are too big to fail and will always get bailed out no matter how egregious their financial transgressions, now attaches to governments themselves.

Greece lived beyond its means, and got rescued by the EU. The irresistible logic is that all the debt of the euro region is now jointly and severally guaranteed -- exactly what the euro’s founders sought to avoid.

The inevitable market response should be to drive bond yields to some average level that is higher than the previously subdued bund yields, now that Germany is effectively on the hook for the debt of all its currency neighbors.

The End of AAA

A similar analysis applies to credit ratings. Germany is a AAA borrower in its own right; if you saddle it with the debt obligations of Greece, Portugal, Spain and others, its grading will have to be lower than the top level. It remains to be seen whether the rating companies, which are under almost daily regulatory threat from European governments for finally doing their job and downgrading weak borrowers, have the backbone to follow through on this logic.

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