Monday, November 21, 2011

Observations From the Back Row

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Italy Looks Like This Cycle’s Lehman Brothers

There has been considerable discussion as to whether the potential Greek default makes it this cycle’s Lehman Brothers, but that is surely wrong. Greece is much too small to destroy large areas of the world economy, as did the bankruptcy of Lehman Brothers. It is also being bailed out on exceptionally favorable, not to say squishy terms, as was Bear Stearns, where shareholders received an entirely unjustified $10 per share from J.P. Morgan Chase. To be Lehman Brothers, one must be a previously undoubted name, albeit with hidden weaknesses in management, whose bankruptcy is large enough to disrupt the entire global economic system and plunge it into depression for years thereafter. There is surely only one candidate for such an honor: it is not Greece, Portugal or Ireland (too small) or Spain (getting better management, and stronger than it looks – think Citigroup) but Italy.

Italy defaults on debt and sends lenders broke? So be it

“Contracting debt will almost infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London …”  — David Hume, Of Public Credit (1742)

The interesting question to ask about the European debt crisis is not what sort of bailout package will work, or which Italian or Greek government should oversee it. Economic forces will overwhelm any political theatrics. The relevant question is how European countries were able to borrow so much in the first place. How did Italy end up with debts of 120% of GDP, or €1.9 trillion? How could Greece, a long-standing economic basket case, borrow as much as 150% of its GDP? The answer seems to demonstrate either the gross stupidity or masterful sophistication of financial markets. These countries, especially Greece, should not have been attractive to lenders. Greece had defaulted routinely on its debts since the early 19th century, and its finances (even the faked ones) were demonstrably shambolic right up to the beginning of the financial crisis in 2008.

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