Bailout

Why it makes sense to fear Greek default

By Felix Salmon

Is everybody overstating the consequences of a Greek default and/or devaluation? The Economist points out that Europe has seen quite a few defaults in recent decades (Russia, Poland) and also break-ups of currency unions (Czechoslovakia, Yugoslavia) — and that none of these events caused a lot of lasting damage.

I’m not convinced, if only because the Russia default caused the collapse of LTCM and a serious crisis; if it weren’t for tough arm-twisting by the Fed and billions of private-sector dollars from America’s biggest banks, it could have been much worse. And the end of the koruna and the dinar also meant the end of the Czechoslovakia and Yugoslavia, and the worry is very much that if Greece or anybody else were to exit the euro, then the whole currency union could fall apart, endangering the EU itself.

More generally, financial markets are good at taking the collapse of risky assets in their stride: what they’re bad at is dealing with the collapse of assets they thought were safe. And until very recently, Greek bonds were considered to be an interest-rate play, not a credit play. As a result, the institutions owning them can ill afford to see big losses on them.

The euro was designed to be a super-safe currency; as such, the repercussions of it falling apart would surely be many orders of magnitude greater than anything we saw in the wake of the collapse of the unlamented Yugoslav dinar.

Mike Kinsley also notes, in the North American context, that if you don’t have an economic union, then other issues tend to get worse — like illegal immigration.

All of which is to say that the great euro experiment seems to be unwinding, the Estonia news notwithstanding, and no one knows where it’s headed over the medium term. If economics and politics become fractious and nationalized across Europe, then within the region only Germany will any longer provide the kind of safety that investors are currently looking for; everybody else is going to start returning to their pre-convergence trade levels, which were a long way away from where we are now.

So anything which threatens the unity of the eurozone or the EU is surely going to have market consequences much worse than a single day drop of a few percentage points on European stock exchanges. And right now it’s far from clear that the political will to keep the union together is going to be sufficient.

Full post as published by Macroprudential on May 14, 2010 (boomark / email).