Monday, May 10, 2010

Is Greece Facing a Liquidity Problem or it it Truly Insolvent?

I imagine that the Jean-Claude Trichet has dealt with more pleasant situations than the one over the weekend.

Last week, Mr. Trichet was broadly quoted as saying that the European Central Bank had not even considered the option of buying European government bonds.

Today, the ECB announced that it would indeed be buying government bonds, but that the Bank did not bow to any pressure in coming to this decision -- see here for a sample of one of the hundreds of stories.

OK, no political pressure but certainly a lot of bond market vigilante pressure!

The issue for the US back in 2008-09 was whether banks were insolvent or illiquid. The line there is a gray one to be sure. I support the lender of last resort stepping in during liquidity crises, which in modern banking systems are inevitable, but not to rescue truly insolvent institutions.

The question then is: is Greece insolvent or just illiquid?

This looks to me like massive monetization of European debt, which will not be good for the Euro. And, unlike the US, much if not most of Europe has very little leeway for additional taxation. The US can solve its debt problems, in the worst case scenario, by increasing taxes, most favorably through a VAT. I am certainly not advocating that we do this; I would prefer to see the pressure kept on to cut spending. But if need be, I think the US could raise several percentage points of GDP through a VAT with very little cost to the economy. I don't think that Greece, or many other European countries, could do that.

Seems to me that insolvency is the more likely situation, and bailing out insolvents cannot be good policy. The only offsetting arguments are that the state of the markets do raise liquidity issues for other countries, if Greece were to be let go.

Tough decision for the ECB.

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