Belmont Club

Orderly Retreat

Bloomberg says that German Chancellor Angela Merkel may have accepted that a Greek default is inevitable. “After almost two years of fighting to contain the region’s debt crisis and providing the biggest share of three European bailouts, Chancellor Angela Merkel is laying the ground for what markets say is almost a sure thing: a Greek default.” The report says efforts are now being focused on keeping banks from being pulled under.

“It feels like Germany is preparing itself for a debt default,” Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London, said in an interview. “Fatigue is setting in. Germany could be a first mover or other countries could be preparing too.”

Officials in Merkel’s government are debating how to shore up German banks in the event that Greece fails to meet the budget-cutting terms of its aid package and is unable to get a bailout-loan payment, three coalition officials said Sept. 9. The move capped a week of escalating German threats that Greece won’t get the money unless it meets fiscal targets and investors raising bets on a default.

Ring-fencing their banks and a hardening of rescue terms risk isolating Germany and unnerving global policy makers already fretting that the region’s political tussles are roiling markets and threatening growth. Underscoring the tone of weekend talks of Group of Seven finance chiefs, U.S. Treasury Secretary Timothy F. Geithner told Bloomberg Television that European authorities must “demonstrate they have enough political will” to end the crisis.

The Telegraph says Germany’s economy minister has characterized the moves as an “orderly retreat”. Other reports suggest that Germany may even be willing to see Greece leave the Euro.

Writing in the Die Welt newspaper, Mr Roesler said: “To stabilise the euro, we must not take anything off the table in the short run. That includes as a worst-case scenario an orderly default for Greece if the necessary instruments for it are available.” …

Mr Roesler’s comments come as Germany’s Der Spiegel magazine said finance minister Wolfgang Schaeuble had ordered preparations be made for a Greek bankruptcy. The report claimed the German government is preparing for two eventualities under that scenario – Greece staying in the euro or the country exiting and reintroducing the drachma.

That Germany should be willing to consider the breakup of the Eurozone speaks volumes for the pressure the currency is under. Liz Alderman in the NYT wonders aloud whether Germany is making a mistake. “There’s little doubt that Germany calls the shots in Europe. But these days, the question is whether they are the right ones.”

This weekend, Der Spiegel reported that the German government was starting to prepare for a Greek insolvency and was devising various responses to handle a potential default, including allowing Greece to abandon the euro and return to the drachma. …

All this has generated severe discomfort in Washington, which has watched the market volatility stoked by the European debt crisis with growing alarm.

Yes it could be a mistake because it signals yet another run of “bad luck” for the administration in Washington which even if it got the half trillion dollars worth of “jobs money” it wants from Congress could see it all wiped out by a tsunami from across the Atlantic.

Other writers at the NYT are mindful that Germany is acting now to prevent something far worse: the encirclement and destruction of the European banking system by the advancing hordes of sovereign bankruptcy. An editorial said “the immediate fear is that one or more major European banks may fail. Confidence is plummeting because they have large holdings of Greek, Spanish and Italian bonds. A major bank failure would damage America’s economy as well — which helps explain the urgent pleas from Washington last week for Europe to come up with a strategy for recovery and growth.” Washington knew how near the bankruptcy zombies were to entering the building and they were shouting at Brussels to shut the door.

Berlin has responded by abandoning the living room and barricading itself in the bathroom. Merkel’s actions suggest that the danger point may have been closer than the pubic statements of European leaders would have the public believe.  But ever the optimists, the NYT see a golden opportunity for governments to take a firmer hold of the financial sector. “The healthy appearance of major bank balance sheets vanishes when future write-downs and partial defaults are factored in. Added capital must be set aside for this contingency, and much of it may have to come from public funds. In return, governments must demand a share of future profits and a stronger regulatory hand.” That is pretty rich considering that government profligacy was among the major factors that precipitated the crisis in the first place. But then that was true even of Freddie Mac and Fannie Mae, and the answer to the poison is now drinking more of the same. The NYT editorial believes that more government spending can yet pull Europe’s chestnuts out of the fire.

European leaders must shift from austerity policies that are leading to recession, not relief. They need to stimulate demand in stronger economies, like Germany, and defer austerity measures in fragile ones. One reason Greece keeps missing its deficit targets is that recession is shrinking tax revenues almost as fast as the government can slash spending. Now Italy, whose growth rates have lagged behind Europe’s for a decade, is being forced to swallow the same bad medicine.

Sure. Anyone can see that the right answer is to spend more government money so that a booming Greek economy can be taxed sufficiently to cover more government spending. If it can work for Greece, why not America? The first stimulus worked so well it is obvious that another would do wonders. Or are we getting the bad medicines mixed up?

The German retreat raises several interesting questions. The first is: why should it stop at Greece? If Spain and Italy are also fundamentally bankrupt then the same arguments that applied to abandoning Greece go double for those two much larger economies. That raises a second question directly:  what is to prevent the retreat from becoming a rout? Having abandoned Athens, can the line be held at Madrid or Rome?

In other words, having abandoned the living room to the zombies, why can Berlin hold at the bathroom? Washington must be hoping the wide Atlantic can keep the waves of bankruptcy from along lapping its shores. But the zombie virus may already be here in the form of moral hazard which forces money to be spent for political purposes. Good the politicians, one supposes, and bad for everyone else.

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