Irreverent Economics

I was an organizer and a panelist in a debate on the LSE perspectives on the sovereign debt crisis yesterday. The podcast is here. It was a lively event. Here are my opening remarks.

This crisis is not about Greece, in same way as the 2007 crisis was not about subprime. Instead, we should be thankful to the Greeks for being so irresponsible.

The sooner the better we can focus on the real problem the better we are, so thank you Greece for focusing our minds. After all, the costs of a Greek default will be couple of percentage points of eurozone GDP, easily manageable

On a general level, we could say this is a systemic crisis in making with 2 sub crisis

1. a banking crisis or a confidence crisis or liquidity crisis
2. Sovereign debt

Let us talk about the banks first. They do have considerable exposure to Greece, and let us be clear about this a key reason is government. In their wisdom, Greek debt is considered safe when it comes to capital while lending to AAA rated Microsoft attracts a significant capital charge. This in spite of the fact that Greek debt was A before the crisis started.

Fortunately, banks have been quite active in writing down Greek debt, even though some are more vulnerable than others. In a way, the crisis demonstrates which banks are weakest. In this, it is interesting to note when the European authorities run stress tests on European banks they assume no sovereign can default.

The second crisis is a sovereign debt crisis. Again, if it was only about Greece it would not be a problem. Even though we can question the morality of having poor well-run countries like Slovenia subsidize much richer Greece. The elephant in the room is Italy. It also is irresponsible but is much bigger. What the European authorities are debating is not the Greek bailout but really the Italian bailout

Each sub crisis is serious but not in any way systemic. What makes it systemic are European politics. They have 2 choices. They can decide to bailout or default. You may have a preference for either of those options but regardless, either will solve the crisis.

Instead, they opted to muddle through. Every time Greece needs another 5 billion, every euro zone country has to agree, a big political fight ensues, newspaper headlines spell doom. It is this uncertainty is creating a systemic crisis.

If Europe will suffer a systemic crisis it is because of its dysfunctional political structure and the shortsightedness of its national leaders. Indeed, if we look at history, none of the really big crisis are created by the financial system. Instead they were all created by politicians. And therefore, inappropriate policy response has been the main cause of all the world’s biggest financial crisis. With that in mind, how can we really expect the politicians to regulate the financial system.

Tags: Greece, sovereign debt crisis, systemic risk

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