Playing Chicken With Greece

The EU remains at a critical point in its young life as it must solve some very serious problems.  The borrowing costs for highly indebted countries like Greece remain at unsustainable levels and they cannot rollover or extend their debt without being deemed in default.  Thus, the current market riot is not unexpected.  The EU central bank, and the economic community at large, knew this was coming because they didn’t solve the problem last year – they just kicked the can down the road.

The EU (controlled by wealthier Germany & France) certainly doesn’t like the position it’s in, but its back is against the wall.  If they let Greece default, then banks all over Europe that have loans to Greece will begin to fail and need rescuing.  As much as the EU resents being put in this position, they have more control of the outcome if they don’t let it spread to the banking system.

As events progress, we are most likely to see a bailout – not a default.  Markets like bailouts, but voters hate them.  However, looking back over the past 3 years, despite all the bailouts that did occur, most people will agree that had Lehman been saved, some of our own financial mess could have been averted.  So, in the end, it’s not that we’ve had too many bailouts, but one too few.  The EU will bailout Greece!

The EU central bank will keep Greece alive by using the Bernanke playbook and digitally conjuring money with a very low interest cost to buy the Greek’s higher yielding bonds and earn a spread on the difference.  The EU’s very own QE2!

As the EU’s central bank ramps up its purchases of Greek debt, it will be able to state that this will help European taxpayers by earning a nice interest payment from Greece while using their very own low cost money to pay off current Greek debt.  To make this work well, the EU central bank will strive to keep their interest rates low to bring down their financing costs; create some inflation to offset the deflation battering the financial system; and weaken the Euro making their companies’ exports more competitive overseas.

If it is this simple, then why haven’t they done it already?  It has and will be politically impossible until the wealthier EU countries believe they have extracted the maximum pain in concessions out of Greece.  This game of chicken is what is currently roiling the markets.  It is the price to be paid to make sure that Greece reforms its ways and the typical EU voter/taxpayer supports the bailout out of fear of a Greek default and a subsequent banking crisis spreading to their home turf.

The EU will deal with the problem, markets will settle down, and we’ll see the Euro continue to weaken and move much closer to 1:1 parity with the U.S. dollar.  However, the road to recovery will be played out with political drama, market volatility, and some good old-fashioned brinksmanship.

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