By Satyajit Das
Despite the media hyperventilation and pundit hyperbole about the downgrade of the US's credit rating, the real issue remains Europe.
There is no imminent danger that the US cannot finance its requirements. The US's cost of debt will not increase significantly as a result of the marginal downgrade by one of the three major rating agencies. Despite the shrill rhetoric, the Chinese and other foreign investors will continue to buy US dollars and government bonds to protect their existing investments.
For many European countries, the inability to access markets is a clear and present danger, which threatens financial markets and the global economy.
The Grand Illusion
(To see why gold might hit $5,000 in two months, click here.)
Echoing Neville Chamberlain's infamous "peace in our time" announcement, the European Union ("EU") on Thursday, July 21, 2011, announced their plan to end the European debt crisis. Unfortunately, the deal is a cease-fire, not a conclusive peace treaty.
The deal includes a euro 109 billion second bailout for Greece, provided by the European Financial Stability Fund ("EFSF") and the International Monetary Fund ("IMF") with a "voluntary" contribution by private sector bondholders, in deference to German insistence.
The new package reduced interest rates charged to Greece to 3.5% per annum, as well as lengthening the maturity of loans from the current 7.5 years to a minimum of 15 years and up to 30 years, with a grace period of 10 years. Portugal and Ireland were also offered the more favorable loan terms.
(To see a story about how the Fed's Plosser takes a few potshots at the Fed, click here.)
In order to reduce the risk of contagion, the powers of EFSF were increased, enabling it to buy bonds in the secondary market (previously only allowed in the primary markets) and buy equity stakes in banks. The EFSF was also authorized to take preemptive action where required. The change is less significant than suggested as the EFSF just takes over the role played by the European Central Bank ("ECB"), which has been active in buying sovereign bonds.
The program called for European public investment to help revive the Greek economy, dubbed by French President Nicolas Sarkozy the European "Marshall Plan," the $13 billion US plan to help rebuild Europe from the effects of World War II. Details of the public investment plan and other elements of the grand compact are sketchy.
Significantly, the EU plan recognized the need for writedowns in the outstanding debt of the peripheral economies. The EU accepted that the extension of debt maturities by private lenders would result in a technical, though hopefully short-lived, default.
(To see Jeffrey Cooper's piece on the great depression, click here.)
The ECB, which had vociferously opposed any "default," was bought off. Other countries agreed to cross-guarantee the (possibly defaulted) Greek bonds provided to the ECB as collateral for funding. This protects the ECB from losses on its euro 130-140 billion exposure to Greece, which is supported by only euro 5 billion in capital (being increased to euro 10 billion).
Several elements of the plan must be ratified by national parliaments in the eurozone members, expected by September 2011 although events may force this to be accelerated.
Christine Lagarde, the new president, has been guarded about further IMF participation, reflecting increasing opposition from emerging market countries. The IMF's share of the first Greek bailout package was euro 30 billion with a similar level of participation required in the second. If the entire European bailout fund was activated, the IMF's share would be around euro 250 billion. Representatives of India and Brazil have voiced concerns about the wisdom of the size of the current exposure, let alone any increase.
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