Occupy Europe
For nearly two years, Europe has tormented itself with increasingly convoluted efforts to avoid the only cure for its countries with excessive sovereign debt: selective sovereign-debt defaults. Last week came yet another self-delusion: news reports have European leaders hoping that the Chinese government will invest tens of billions of dollars in euro debt to help distressed European nations avoid default. The money would come with strings attached. In fact, a deal with China likely would be the ultimate self-inflicted deformity: Europe would give up some of its rights to free political speech so that it could use Chinese money to hold the withering judgment of free markets at bay for a while longer.
As with everything related to the ongoing global financial crisis, the situation is incredibly complicated. Last week, Europe pretended once again to have fixed its debt problem. Under the latest plan, lenders to Greece, including big French banks, are supposed to take a “voluntary” loss of half the face value of their Greek bonds. French president Nicolas Sarkozy and German chancellor Angela Merkel have insisted on this “voluntary” canard because an “involuntary” loss would be, well, a default. Official Europe wants to avoid a default, which would mean big payouts for speculators who bought “credit-default swaps”—yes, those things again—in anticipation of such a disaster. Europe wants to punish the speculators, whom the politicians blame for precipitating the sovereign debt crisis in the first place.
But this political and financial alchemy is itself a gamble. It’s not only speculators who bought the financial instruments that were supposed to pay off in the event of default. Investors who hold Greek bonds purchased them, too, to protect their bond investments (as bond prices go down, swap prices should go up). These investors have also bought credit-default swaps as a hedge against Italian, Portuguese, and Irish debt—and now they’re wondering if such “insurance” is worthless. “If you owned a sovereign bond and you got scared because you bought [credit-default swaps] thinking [they] would pay out, you’ll realize you would have been better off just selling your bond—and you’ll just get rid of everything,” AllianceBernstein’s co-head of credit, Ashish Shah, told the Wall Street Journal.
Since nobody sells a financial instrument that hedges against the risk of political default, investors don’t know quite what to do. It’s unlikely that they’ll start putting money into the bonds of the other struggling countries. These countries need new money, though, to refinance their existing debt. Indeed, last Friday, after the latest deal for Greece was announced, Italy had to pay even higher interest rates on its own new borrowing; it can’t keep that up for long. Unless Europe inflates its way out of this crisis, prevailing upon its central bank to print money to buy up all the stranded bonds, more Greek-style restructurings on other European sovereign debt are inevitable. And we haven’t heard the last from Greece: Monday, prime minister George Papandreou said that he wants to give Greek voters a direct say—via referendum—in the budget cutbacks they must bear as a condition of European aid.