Do you believe that last week’s agreement by European Union (EU) leaders will finally solve the Greek government’s debt crisis? It’s awkward to express exuberance about it; after all, the Greeks will continue to experience many years of fiscal austerity before their government’s debt is reduced to manageable levels. And if the bitter pill of austerity prevents economic prosperity, the Greek nation may not experience sustained growth for a generation.
At the moment, though, our global markets appear to believe that the agreement represents a huge step in the right direction. At the end of last week, the Dow Jones Industrial Average was on track to complete its strongest October in history. And many analysts hailed the agreement as an historic success, though some cautioned that investors should wait and see how the terms are implemented before celebrating its consummation.
Lost in much of the hoopla, though, was an important clause that had not previously appeared in similar government debt agreements. Interestingly, the clause illustrates how the European approach differs from the American approach on a fundamental level.
Let’s Make A Deal!
The challenges facing Greece and its EU partners are quite imposing. Each nation member is legally required to limit its federal government debt to 60% of its national GDP, but because of the ongoing economic malaise, the overall EU debt level has soared to 80% of GDP. And Greece’s debt level is the highest of all nations; it soared to 142% in 2010 and is forecast to remain above 130% of its GDP next year.
Because a Greek default on its debt would deliver a huge blow to its creditors, and because many of its creditors are European banks that are considered “too big to fail” by their governments, a Greek default is now considered an existential economic threat to the EU itself. European leaders have been struggling for months to devise a way to support the Greek government without taking the politically unpopular step of bailing out its profligate (and, arguably, fiscally irresponsible) member state.
Last week’s solution encompassed a commitment by the EU leadership to guarantee up to $1.4 trillion of the government bonds of fiscally weak European states. In exchange for this support, the Greek government agreed to new austerity measures that would reduce its debt load to 120% of GDP by the year 2020; furthermore, all European banks would be required to increase their capital reserves by $147 billion.
Perhaps most surprisingly, EU leaders convinced global private banks that have invested in Greek government debt to “voluntarily” forgive 50% of the outstanding principal on their loans. This clause was indeed a unique one; in contrast, the United States government failed to convince any of the holders of the debt of bailed-out American financial institutions to agree to any reductions in principal balances.
Merkel vs. Paulson
What are the accounting implications of a “voluntary” 50% reduction in principal by the private banks? Well, the firms will write off significant asset balances, which will reduce their equity book values accordingly. And because their capital reserve requirements are increasing in compliance with last week’s agreement, a larger share of their dwindling asset balances will necessarily be diverted to satisfy those requirements, thereby leaving fewer funds available for lending and investing activities.
On the one hand, some may predict that this will inevitably lead to less business activity and slower economic growth. On the other hand, skeptics may scoff that global banks have not been aggressively seeking out new growth opportunities any way, and thus the new regulations will not significantly impact growth.
German Chancellor Angela Merkel has been widely praised for demanding the 50% write-down from private sector banks. Her negotiating position, in fact, provides a dramatic contrast to that of former U.S. Treasury Secretary Hank Paulsen, who didn’t demand any such write-downs and reportedly sunk (literally) to his knees to beg Democratic legislators to fully bail out all “too big to fail” banks during the market collapse of 2008.
It’s tempting to conclude that Chancellor Merkel did a better job of protecting taxpayer interests than Secretary Paulson. However, it will take a while for the long term results to become evident.
On the one hand, if the EU’s massive asset write-down cripples European banks (and thus the EU economy) for years, then Merkel’s victory may be viewed ultimately as a pyrrhic one. Conversely, if the U.S. government ever defaults on its debts, then Paulson’s decision to bail out 100% of the debt of the “too big to fail” institutions may be perceived eventually as a foolhardy choice.
At the moment, though, Merkel’s approach is undoubtedly the more popular one with voters in both the EU and the U.S. In fact, with such unproven candidates as Herman Cain riding high in the opinion polls at the moment, Merkel herself might have been able to win the American Presidential election if she had been eligible to run for that office.