Komal S. Sri-Kumar

Chief Global Strategist

February 16, 2010

Greek Bailout: This is A Trojan Horse!

One of mythology’s most vivid lessons in unintendedconsequences is the story of the Trojan Horse – thesneak attack that enabled Greek soldiers to secretlyenter and destroy the ancient city of Troy. I fear theEurozone powers may be reenacting this story in theirefforts to rescue Greece from a debt crisis, only thistime, they themselves are building the Trojan Horsethat will soon haunt them. Advice: beware the bailoutof Greece, it brings unintended consequences thatcould weaken the entire Eurozone.By way of background, it is worth recalling thatGreece was not among the founding members of the Eurozone in 1999, instead gaining admittancein 2001 after convincing founding Eurozone membersthat Greece had the necessary fiscal discipline to jointhe monetary union. The move to the euro immediatelybenefitted Greece – concerns about its currency, thedrachma, evaporated, and investor doubts about Greekmonetary policy quickly disappeared. The drachmawas replaced by the euro, and monetary policy for theentire Eurozone was administered out of Frankfurt,not Athens. Soon, Greek businesses and consumershad access to a stable currency and lower interestrates, and growth accelerated. It was exactly the kindof economic stability the Eurozone had promised,and with the staging of the 2004 Olympics in Athens,Greece appeared to be a commercial for Eurozonesuccess.The temporary prosperity, however, hid a dirtyeconomic secret: a continuing lack of fiscal disciplinein Athens, where government spending was surging,causing government debt to grow much faster thanthe underlying Greek economy. The current debt crisiscame to light only when the new Papandreougovernment disclosed in late 2009 that the previousgovernment had doctored and under-reported the sizeof the fiscal deficit. The estimated deficit figure forthe 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, theypunished not just Greek debt, but the debt of Portugaland Spain as well. Spreads on Greek bonds vs. theGerman Bund, and the cost of obtaining insuranceagainst a Greek sovereign default, both increasedsignificantly, demonstrating a clear lack of confidencein Greece’s ability to manage its way out of the crisis.The result: a widening debt crisis that has set inmotion what is now widely characterized as the mostserious crisis of the Eurozone in its brief history.

Greece: Public Spending (% of GDP)

38%40%42%44%46%48%50%52%2003 2004 2005 2006 2007 2008 2009

Sources: Eurostat

Pernt

The Greek Crisis Exposes the Eurozone’sStructural Weakness

The crisis in Athens is clear evidence of a deepstructural flaw in the conception of the Eurozone:it was created as a monetary union in the absenceof a political union, and without a capacity for fiscal

transfers between nations. The 16-member countriesoperate their fiscal houses independently, with nocoordination, or even close monitoring, by a centralauthority. Fiscal policy is, at best, a hodge-podge.To borrow from another well-known myth, this is theAchilles Heel of the Eurozone: not just a lack of coordination in fiscal planning and policy, but theinability to use coordinated monetary and fiscal policyto respond to an economic downturn. The region has16 separate fiscal policies, each subject to the politicalwhims of the authorities and taxpayers in 16 countries.This sharply reduces the ability of the European CentralBank to respond swiftly and effectively to problems asthey arise. In contrast, this is one of the acknowledgedstrengths of the U.S. system: the ability of the U.S. Fedand the U.S. Treasury to coordinate monetary andfiscal policy, both in good times and bad. FedChairman Ben Bernanke accomplishes some of thiscoordination in the simplest of meetings: frequentprivate luncheons with Treasury Secretary Geithner.The president of the European Central Bank, Jean-Claude Trichet, has no such lunch partner, and nosuch opportunity for policy coordination with any of the 16 Finance Ministers. Instead, he has 16 verydifferent governments to deal with. To confusematters, he now knows one of those governmentshasn’t even been telling him the truth about its fiscalstate.

Greece: Fiscal Deficit (% of GDP)

024681012142001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: Eurostat & TCW Global Strategy

Pernt

A Bailout for Greece is Bad for Europe

A principal reason for the growing uncertaintysurrounding the situation is that in the Eurozonecharter, there is no mechanism to bail out a memberunless the difficulties are due to natural causes, orstem from forces “beyond that member’s control.”It is hard to argue that falsified data, and relentlessgrowth in public spending belong in this category.Still, as hopes for Greece being bailed out rose, CDSspreads, which measure the cost of insuring againstthe risk of default, fell in the case of Greek, Portugueseand Spanish debt over the past few days.

Five-Year Credit Default Swaps (USD)

050100150200250300350400450

1 2 / 1 / 2 0 0 9 1 2 / 8 / 2 0 0 9 1 2 / 1 5 / 2 0 0 9 1 2 / 2 2 / 2 0 0 9 1 2 / 2 9 / 2 0 0 9 1 / 5 / 2 0 1 0 1 / 1 2 / 2 0 1 0 1 / 1 9 / 2 0 1 0 1 / 2 6 / 2 0 1 0 2 / 2 / 2 0 1 0 2 / 9 / 2 0 1 0

Source: Bloomberg

Basis Point

Greece Portugal Spain

If Europe rushes to the aid of Greece, it will be bailingout and backing a country that has yet to demonstratethe political will to enact tough austerity measures.Every indication is that Greece will relapse and needadditional help. Should resources be used now tobolster a country that seems likely to fail again,probably in just a few months?Furthermore, a rescue of Greece sends the wrongmessage to other Eurozone governments facing toughfiscal choices. Why would Portugal or Spain take thepainful steps necessary to put their fiscal houses inorder if Greece was not required to do the same? Whynot just wait for the next bailout from Berlin?And lastly, why should the taxpayers of Germany, whohave an incipient fiscal problem themselves, be forcedto bail out Greek politicians and civil servants whofailed to make tough choices? Such a one-sidedsacrifice fosters the exact opposite of regional unity:indeed, it is likely to breed resentment in Germany andultimately weaken the Euro zone’s unity. Notsurprisingly, the tough negotiating stance taken lastweek by German Chancellor Angela Merkel – she isreported to have made specific demands even on howmuch the Greek value added tax should increase by inorder to qualify for external assistance! – hasoverwhelming support with the German electorateeven as it threatens further Greek protest marches.