It’s hard to feel sorry for the Europeans, whose current economic woes are very much of their own making.
When they created the euro exactly ten years ago, they included quite different economies. At one end were the major industrial powers: France, Germany, UK and other western European countries. At the other end was southern Europe: Portugal, Spain, Italy and Greece. To cover this disparity, strict rules were put in place to ensure economic discipline, particularly when it came to debt levels member countries were allowed to hold. But after the euro was set up, breaching EU rules on debt became commonplace, with the transgressors acting with impunity for they knew that they would not be held accountable.
With the euro in place, the EU became a dysfunctional family with no one at its head willing to kick butt when rules were broken.
In some ways, the causes of the current crisis in the euro are unrelated to the misjudgments and crimes that led to the global financial crisis of 2007-8. However, the consequences may well be the same as Greek and Italian debt is owed to major banks all around the world, many of which are still too-big-to-fail.
What makes the situation even worse is that through opaque financial derivatives, it is not possible to predict which banks are exposed to sovereign debt. Thus, when a major bank starts to totter, expect the credit market to freeze over again as it did in 2007-8, as no one knows which other banks are counterparties to the failing bank and are therefore at risk.
In trying to sort out the mess, a new and seemingly intractable problem has arisen. Normally, when a country is having difficulty paying back sovereign debt, its bondholders are forced to take a haircut, which simply means that they take a loss. Once bondholders see that they are highly unlikely to recover the money they loaned to the delinquent country, logic would suggest that they should agree.
In the case of Greece, bondholders are being asked to take a haircut of the order of 60%, not unreasonable considering the state of the Greek economy. However, banks are refusing to enter into such an agreement—for very good reasons.
Many have taken out insurance in the form of a derivative called credit default swaps (CDS), which recovers all their money if Greece officially defaults. If those banks voluntarily accept a haircut, the conditions for the CDS are not triggered and they get nothing.
Derivatives have been extolled because they efficiently distribute risk. However, there is a downside. The party making the decisions on the Greek default (i.e. the banks) are not the same parties who will have to pay out (i.e. counterparties to the CDSs).
With such perverse incentives operating, a rational pathway out of the Greek mess is being blocked.
After the first global economic crisis, governments had an opportunity to rein in derivatives (CDS in particular), which were rightly labeled by Warren Buffett as “weapons of mass destruction.” Under intense lobbying from the financial sector, reforms were watered down, which means the fundamental problems of derivatives are still with us, as the Greeks are finding out at their expense.