“Bubbles are back as a topic of serious discussion, as they were before the financial crisis. The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?
Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit. But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse. A few investors can do well by betting against such bubbles, but it’s harder than you might think because you have to get the timing right – and that’s much more about luck than skill.
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To think about this more specifically, consider the case of Greece today. It might seem odd to suggest there is a bubble in a country so evidently under financial pressure – and working hard to stave off collapse with the help of its neighbors – but the important thing about bubbles is: Don’t listen to the “market color” (otherwise known as ex post rationalization), just look at the numbers.
By the end of 2011 Greece’s debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time – for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently). About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany. Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.
What if Greek interest rates rise to, say, 10% – a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called “austerity” program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe? Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).
This is simply impossible and unheard of for any long period of history. German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings). Neither of these were good experiences.
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If such measures are not taken, we are clearly heading for a train wreck. The European politicians have been tested, and now we know the results: They are not careful, they are reckless.”
Peter Boone and Simon Johnson, "The Coming Greek Debt Bubble", The Baseline Scenario Blog (11 March 2010).
http://baselinescenario.com/2010/03/11/the-coming-greek-debt-bubble/
Peter Boone is chairman of the charity Effective Intervention at the London School of Economics' Center for Economic Performance. Simon Johnson is Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 Professor Johnson was Chief Economist of the International Monetary Fund.
Let us be clear on this: The Greek debt situation is unsustainable and sooner or later the entire mess will come crashing down. So the question is who will pay.
Why should the Greeks pay? Creditors in France and Germany have known for a decade that the Greeks were living well beyond their ability to repay any loans, and yet they loaned the money to Greece anyway. Even now, the French and German governments in an act of continuing stupidity are encouraging their financial institutions to buy Greek bonds. Any idiot can see where this is all heading. Granted, abandoning the Greeks in their hour of need would be a disaster. But any idiot can also see that if the Greeks are bailed out an even greater disaster is on the horizon, one that could engulf the entire European Community. Better to cut the losses now, not just in Greece but elsewhere in the EU, rather than risk the much greater disaster to come. Given the stupidity of the French and Germans, and the terribly high price -- a overwhelmingly crushing price -- the Greeks will have to pay if they try to pay back the debt, maybe the Greeks ought to just repudiate the debt and tell the French and Germans to eat the debt as the price they must pay for lying to their citizens about the creditworthiness of the Greek government. While this is not good for Greece, it is much better than many years as a slave to French and German financial interests, transferring a significant and growing percentage of its GDP to foreigners.
Why should the French and the Germans pay? Creditors in France and Germany made loans to the Greeks in good faith, with assurances that Greece would change its ways and guarantees they would be paid back. In this sense, these were not reckless loans but extended in the expectation that conditions for sustainability were being established and the rules of the Maastricht Treaty, mandating sensible macroeconomic policies, would be enforced. French and German banks, pension funds, and other investors were encouraged -- nay, virtually told by their governments – to buy these bonds, because their governments, in an act of delusion we call a Ponzi scheme, saw the continued financing of Greece as a way to pay the interest on the previously issued bonds. But surely Greek politicians were knowingly at the center of this scheme to defraud the French and the German financial sector; even now, they continue to promote this dishonest scheme for their own benefit, forcing the French and the Germans to become slaves to the Greek standard of living. It is the Greek politicians, manipulating and lying to their French and German counterparts and acting on behalf of the Greek government and a selfish Greek people, that caused this problem, so the Greeks must pay as their debt collapses under the weight of their deception and greed.
We do not know how this will play out. But play out it will, and however it does it will not be pretty. For the moment, the Ponzi scheme that is Greek debt builds before our eyes as governments, rather than bursting this bubble, encourage an ever-increasing flow of money into what in the end will be a black hole of financial ruin. But do not forget that because governments are orchestrating this disaster as they blindly try and run away from its consequences, many of those throwing even more money into this bottomless pit expect to be bailed out in the end. So it is likely to continue for a while.
And less us note that Greece is not the only country led by reckless and irresponsible politicians that base its national budget on a Ponzi scheme. That country, too, is on a course that cannot end happily.
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