Old Euro Dogs

This morning Euro Zone policymakers announced an agreement where certain private investors (mainly banks and insurance companies) would take 50% haircuts on their holdings of Greek debt.  This is basically a managed default.  And though it runs totally contrary to what policymakers were promising earlier this year (aka that Greece would not default), it really should have been expected.

Back peddling or not, this is a righteous step that should be applauded.  This was a responsible step that should have been taken a long time ago.  The initial plan, which was to cobble together a series of bailout loans to help Greece sidestep one crisis after another was ridiculous and doomed to fail from the start.  Credit markets smelled the farce and sent Greek bond yields through the roof – the yield on 1-year Greek government bonds went over180% in October!

Now that people are finally willing to call Greece what it is (bankrupt and insolvent), the long process of fixing its broken financial system can finally begin.  Allocating losses to those who deserve them, i.e. investors that explicitly took on risk in pursuit of profit, is the first step.  This is an essential component of a properly functioning free market, one that rewards good decisions, punishes bad ones, and reallocates resources to their most productive use.

It is encouraging to know that Europe recognizes this and is doing the right thing. U.S. policies, on the other hand, have moral hazard written all over them.  Our government has basically decided to protect the interests of a privileged few by forcing innocent bystanders to pay for their mistakes (i.e. public payouts that benefit big banks).  These policies reinforce and reward reckless and irresponsible behavior, and do nothing to fix the underlying problems.

While America prefers the latest innovations over Europe’s old-school traditions, this 50% haircut is one European example that Americans should really follow.  When it comes to financial innovation, those old dogs across the pond may not be able to learn new tricks, but in terms of enforcing good old fashioned gains and losses, they can still teach us a thing or two.

Victor K. Lai, CFA

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