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Neil K. Shenai

Neil K. Shenai

Posted: February 15, 2010 02:24 PM

Plato's Bankrupt Republic

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The Greeks have a penchant for being ahead of the curve. With the rest of Europe mired in tribal warfare, the Athenians built a democracy. Three thousand years before the Cold War, the Greeks mastered bipolar conflict and founded the realist international relations tradition, as told by Thucydides in his brilliant History of the Peloponnesian War. Surely this trend-setting tendency, then, should alarm Western observers who face Greece's current debt crisis.

Aided and abetted by the same brilliant financiers who sponsored fiascoes like the Enron bankruptcy and the subprime mortgage meltdown, it appears as though Greece partook in its own form of accounting subterfuge, masking billions of Euros worth of its debt in currency swaps and securitized borrowing based on fictitious future cash-flows that, per custom, failed to materialize.

The result is a government teetering on the brink of insolvency. Greece's budget deficit as a percentage of its GDP is approximately 13%, according to the Economist Intelligence Unit. Its gross national debt is 120% GDP, the highest of any European Union member. And its 10-year borrowing costs are steadily rising as investors lose confidence in the Greeks' ability to repay their staggering debt.

Currently, the EU is doing what it does best, deliberating about a future course of action. They would be wise to heed some earlier lessons from the American financial crisis that became apparent with hindsight. In short, the EU should act big and act fast in response to Greece's fiscal crisis.

Acting big would require the EU to pass a Union-wide policy of bailing out any members with fiscal problems. Paradoxically, by guaranteeing the solvency of its members, the run on Greece's debt would stop, thereby obviating the need for the guarantee in the first place.

Although such an approach would likely draw the ire of fiscally responsible members such as Germany, the costs of inaction simply outweigh the costs of preemption. The EU should not underestimate the likelihood of broader financial contagion within the Eurozone. Authorities would be remiss to dismiss Greece's troubles as purely idiosyncratic, as countries like Portugal, Italy, and Spain also boast weak fiscal positions, high unemployment, and large debt to GDP ratios. If Greece were to fail, these countries would be soon to follow. History tells us as much:

At the time, in March 2008, many regulators in the United States viewed Bear Stearns' solvency issues as unique to their particular business. Instead of laying the foundation for a broader, system-wide response that could have forestalled the bankruptcy of Lehman Brothers, the Treasury Department and Federal Reserve were notably quiescent. In the mean time, asset prices continued to fall, banks were slow to write off their portfolios of non-performing loans, and the financial crisis claimed another victim, Lehman Brothers. By embracing an ad-hoc approach to member solvency issues, the EU risks enabling a domino effect of defaults across its membership, much like the American ad-hoc approach led to the cascading wave of defaults that led to the Lehman bankruptcy.

Secondly, by deliberating, adding conditions, and otherwise delaying eventual respite to the Greeks, the EU risks adding to the momentum of the current financial market swoon. The EU's emphasis on Greece's austerity measures is well-intentioned but ill-timed. It is far better to reform fiscal profligacy in a situation of economic stability than in one of full-blown crisis. By failing to acknowledge the potentially systemic character of this sovereign debt crisis, the EU risks wasting precious time that could prevent an even deeper crisis of confidence in its other members.

If history is any guide, Greece's sovereign debt crisis is likely the first shoe to drop in a series of fiscal crises in the advanced industrialized world. The United States and Britain both face looming fiscal crises of their own. Maybe Greece's troubles will help jump-start aggressive budgetary reforms elsewhere. Regardless, all countries must accept that preventive medicine might taste bad, but allowing the sovereign debt crisis to fester will only lead to more pain down the road.

Indeed, this is the first true test of the European Union since its founding. By failing to help one of its prodigal members, the specter of sovereign debt crises will continue to haunt its membership. As Plato astutely observed three millennia ago, "as the builders say, the larger stones do not lie well without the lesser." France and Germany should keep this in mind when crafting policy towards their wayward Mediterranean counterpart.

 

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