Most Popular ArticlesGreek Bailout: This is a Trojan Horse!
TCW Asset Management
Komal S. Sri-Kumar
March 5, 2010
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One of mythology’s most vivid lessons in unintended consequences is the story of the Trojan Horse – the sneak attack that enabled Greek soldiers to secretly enter and destroy the ancient city of Troy. I fear the Eurozone powers may be reenacting this story in their efforts to rescue Greece from a debt crisis, only this time, they themselves are building the Trojan Horse that will soon haunt them. Advice: beware the bailout of Greece, it brings unintended consequences that could weaken the entire Eurozone. By way of background, it is worth recalling that Greece was not among the founding members of the Eurozone in 1999, instead gaining admittance in 2001 after convincing founding Eurozone members that Greece had the necessary fiscal discipline to join the monetary union. The move to the euro immediately benefitted Greece – concerns about its currency, the drachma, evaporated, and investor doubts about Greek monetary policy quickly disappeared. The drachma was replaced by the euro, and monetary policy for the entire Eurozone was administered out of Frankfurt, not Athens. Soon, Greek businesses and consumers had access to a stable currency and lower interest rates, and growth accelerated. It was exactly the kind of economic stability the Eurozone had promised, and with the staging of the 2004 Olympics in Athens, Greece appeared to be a commercial for Eurozone success. The temporary prosperity, however, hid a dirty economic secret: a continuing lack of fiscal discipline in Athens, where government spending was surging, causing government debt to grow much faster than the underlying Greek economy. The current debt crisis came to light only when the new Papandreou government disclosed in late 2009 that the previous government had doctored and under-reported the size of the fiscal deficit. The estimated deficit figure for the year was raised all the way from 3.7% to 12.7% of GDP! When investors learned of the higher figure, more than four times the Eurozone’s limit, they punished not just Greek debt, but the debt of Portugal and Spain as well. Spreads on Greek bonds vs. the German Bund, and the cost of obtaining insurance against a Greek sovereign default, both increased significantly, demonstrating a clear lack of confidence in Greece’s ability to manage its way out of the crisis. The result: a widening debt crisis that has set in motion what is now widely characterized as the most serious crisis of the Eurozone in its brief history.
The Greek Crisis Exposes the Eurozone’s The crisis in Athens is clear evidence of a deep structural flaw in the conception of the Eurozone: To borrow from another well-known myth, this is the Achilles Heel of the Eurozone: not just a lack of coordination in fiscal planning and policy, but the inability to use coordinated monetary and fiscal policy to respond to an economic downturn. The region has 16 separate fiscal policies, each subject to the political whims of the authorities and taxpayers in 16 countries. This sharply reduces the ability of the European Central Bank to respond swiftly and effectively to problems as they arise. In contrast, this is one of the acknowledged strengths of the U.S. system: the ability of the U.S. Fed and the U.S. Treasury to coordinate monetary and fiscal policy, both in good times and bad. Fed Chairman Ben Bernanke accomplishes some of this coordination in the simplest of meetings: frequent private luncheons with Treasury Secretary Geithner. The president of the European Central Bank, Jean-Claude Trichet, has no such lunch partner, and no such opportunity for policy coordination with any of the 16 Finance Ministers. Instead, he has 16 very different governments to deal with. To confuse matters, he now knows one of those governments hasn’t even been telling him the truth about its fiscal state.
A Bailout for Greece is Bad for Europe A principal reason for the growing uncertainty surrounding the situation is that in the Eurozone charter, there is no mechanism to bail out a member unless the difficulties are due to natural causes, or stem from forces “beyond that member’s control.”Â
It is hard to argue that falsified data, and relentless growth in public spending belong in this category. Still, as hopes for Greece being bailed out rose, CDS spreads, which measure the cost of insuring against the risk of default, fell in the case of Greek, Portuguese and Spanish debt over the past few days.
If Europe rushes to the aid of Greece, it will be bailing out and backing a country that has yet to demonstrate the political will to enact tough austerity measures. Every indication is that Greece will relapse and need additional help. Should resources be used now to bolster a country that seems likely to fail again, probably in just a few months? Furthermore, a rescue of Greece sends the wrong message to other Eurozone governments facing tough fiscal choices. Why would Portugal or Spain take the painful steps necessary to put their fiscal houses in order if Greece was not required to do the same? Why not just wait for the next bailout from Berlin? And lastly, why should the taxpayers of Germany, who have an incipient fiscal problem themselves, be forced to bail out Greek politicians and civil servants who failed to make tough choices? Such a one-sided sacrifice fosters the exact opposite of regional unity: indeed, it is likely to breed resentment in Germany and ultimately weaken the Euro zone’s unity. Not surprisingly, the tough negotiating stance taken last week by German Chancellor Angela Merkel – she is reported to have made specific demands even on how much the Greek value added tax should increase by in order to qualify for external assistance! – has overwhelming support with the German electorate even as it threatens further Greek protest marches.
The Greek Bailout, in this sense, is indeed a kind of Trojan Horse – if it is allowed into the Eurozone, it brings with it problems currently limited to Greece, and spreads the pain throughout the 16-nation union. It is planned contagion. I would suggest that the long-term interests of the Eurozone are better served by denying Greece a bailout, even if it means that Greece withdraws from the Eurozone and, in the process, weakens the euro significantly, say, from the recent $1.35 – 1.36 level to $1.20.  A weaker euro would actually be quite popular in export-oriented Germany, and be generally welcomed in the entire Eurozone as enhancing the competitiveness of the region. Also, inflation is currently well below the ECB’s preferred level of around 2% allowing room for any inflationary consequences of a euro depreciation to be manageable. Second, absence of a Greek bailout would lower the risk of moral hazard inherent in Portugal and / or Spain following in the same path if Greece does receive a bailout. Despite the temporary weakening of the euro that might result from, say, Greece’s departure from the Eurozone, the emphasis on fiscal health would have a beneficial impact on the medium-term course of Eurozone inflation and of the euro itself. Leaders of the Eurozone should view the Greek debt crisis as an opportunity to correct for weaknesses inherent in the system’s structure. Since absence of organized, fiscal transfers is a major factor in the escalation of the current crisis, authorities need to devise steps for providing fiscal assistance when necessary and justified. The Eurozone needs to move toward becoming an economic union supported by consistent regional fiscal policies which are monitored more closely than they have been in the past. Such a coordinated policy would begin with a Stabilization Fund, and might even provide the rescue Athens currently needs. But saving Greece should not be the main goal. Building a stronger Eurozone is more important than saving Greece.
Komal S. Sri-Kumar Komal S. Sri-Kumar Chief Global Strategist Disclaimer This publication is for information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analyses with respect to a particular company, security or the economy than the views expressed herein. This report may include estimates, projections and other "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. This publication is not to be used or considered as an offer to sell, or a solicitation to an offer to buy, any security. Nothing contained herein should be considered a recommendation or advice to purchase or sell any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. ©Copyright 2010 865 South Figueroa Street  |  Los Angeles, California 90017  |  213 244 0621  |  www.tcw.com (c) TCW
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