Saturday, July 23, 2011

Xie: Great summer slowdown

Global Economy on a Slow Summer Burn
By Andy Xie


It appears euro zone countries have managed to keep Greece afloat for the time being by providing cash assistance and getting bondholders, mainly West Europe banks, to accept a "voluntary" rollover. This deal merely kicks the can down the road. When the next wave of Greek bonds comes due, we'll see the drama repeated. Rolling over debt doesn't make the debt good, and even a rookie analyst can see that Greece can't pay its debt.

The economy in Greece is only 2 percent of the European Union's. Its national debt is 340 billion euros, less than 2 percent of total EU credit outstanding. So, in theory, a Greek bankruptcy would be no worse than that for a major corporation – painful but manageable. Besides, bankruptcy is inevitable unless someone else pays a national debt level equal to around 80,000 euros for each of Greece's 4.4 million citizens.

Why are European governments trying so hard to delay the Greek bankruptcy? Because the nation's finances are linked to the wider banking system, with two-thirds of the money owed to western banks and other foreign investors. Hence, France and Germany in particular are trying to delay it.

But the delay is just an accounting gimmick. Investors have obviously lost money, and it's sad to see European governments engage in this self-deception. Greek bonds are already pricing in bankruptcy by trading at massive discounts to par. If banks with bonds mark to market, they'd have to recapitalize immediately.

Three big rating agencies are challenging European practices by noting that the debt rollover is de facto bankruptcy. Their opinion matters because the European Central Bank can't hold bankrupt government bonds as collateral. U.S. banks pledged worthless subprime paper to the Federal Reserve to secure loans during the 2008 crisis, and now European banks are doing the same to the ECB.

Obama on a back foot.

President Obama made a big mistake when he listened to economists who advised big stimulus to get the economy and employment going again after the 2008 crisis. It would have been better to let the economy land where it would, and then recover on more solid ground in time for the 2012 election.

That's what Ronald Reagan experienced when he was president in the 1980s. Then-Fed Chairman Paul Volker raised interest rates aggressively to tame inflation and the economy crashed. But recovery came by the time Reagan was seeking re-election in 1984. He won. By then, the economy had cleaned out most of the dirt that accumulated during the high-interest rate period.

In hopes of winning the election, Obama may add to his previous mistake by piling more stimulus, providing a temporary fix but setting the stage for another crash later.

Another byproduct of Obama's mistaken policy is a new round of declines for property prices. Based on historical data, U.S. housing prices should have been cut in half after the 2008 crisis, but the government stimulus and the Fed's QE 2 gave property owners hope for recovery. So they hesitated, and the market recovered a bit last year, only to deflate hopes again. That led to the current wave of defaults, triggering another price decline.

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