1. What Do Bubbles Have to Do With Greece?
2. Why Is There So Much Resistance to Bailing Out Greece?
3. How Could Such a Small Country as Greece Affect the Whole World?
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1. What Do Bubbles Have to Do With Greece?
In the year 2000, the stock market began a dizzying fall that was triggered by a sharp decline in technology and internet stocks. Subsequently, this event became known as the bursting of the internet bubble. The internet bubble was spawned in part by what Alan Greenspan described as “irrational exuberance” in the stock market regarding internet stock price valuations. When this bubble burst, the Federal Reserve lowered interest rates to try to support the economy and help it to recover more quickly. An unintended consequence of lowering interest rates was the creation of a housing bubble with home values soaring to new highs. The good news was that individuals didn’t feel the full effect of the bursting of the internet bubble (even though unemployment rose sharply) because home values increased rapidly and people were able to borrow against their home equity to tide them over during the recovery.
However the housing bubble was much larger than the internet bubble. As the housing bubble grew, financial services companies jumped vigorously into the rising tide of real estate valuations. The returns were so good that individuals as well as businesses found ways to invest more aggressively in real estate by dramatically increasing their borrowing leverage. Freddie Mac among others was able to achieve remarkably high leverage on their securitized debt instruments.
When the real estate bubble burst there were whole industries that were suddenly at risk of financial collapse. The old financial concept of “tough love” where individuals and firms have to live with the full consequences of their bad choices quickly evaporated when the financial services firm Lehman Brothers went bankrupt and the contagion from this event spread so quickly and so far that it became a struggle to contain it. There was an organized effort to have the stronger financial services companies bail out the weaker firms but it quickly became evident that the size of the required bailout would exceed the resources of private industry, and that the economy would have to turn to the lender of last resort to fund this much-larger bailout effort. This was when central banks and governments initiated extraordinary measures of both monetary and fiscal policy stimulus to sustain the stumbling economies of the world. Quantitative easing at central banks and sovereign debt expansion in national governments became standard procedure in nation after nation around the world.
2. Why Is There So Much Resistance to Bailing Out Greece?
Which brings us to 2015 and the Greek debt crisis. But first a word about bubbles and bailouts. A bubble generally describes an economic condition where the value of something is “inflated” beyond its normal or rational bounds. Some American examples of historical bubbles might include the railroads and copper in the late 1800’s, the stock market in the 1920’s, and the dotcom stocks in the 1990’s, among others. Smaller bubbles come and go all the time - especially in capitalist economies. Fortunately, larger bubbles are less common.
When a bubble bursts, there is often a sudden readjustment of value of the underlying asset from an inflated level to a much lower level, sometimes below its normal or rational level. If the inflated value is high enough, this drop in value can suddenly thrust firms or individuals who own the underlying asset into abrupt insolvency or bankruptcy. If the bubble is big enough, it can put at risk whole industries or even whole national or international economies. In order to avoid these negative consequences, it is not uncommon for interested parties to “bailout” the affected firms or individuals by providing them some form of third party financial assistance to avoid bankruptcy. Banks are generally the first line of providing financial assistance to distressed individuals or firms. However if the required bailout is large enough, the only recourse may be to seek a bailout provided by the government.
In most instances of bursting bubbles, the affected industry or economy is sufficiently strong that the disruption and dislocation is not deemed significant enough to justify a government bailout. (Government bailouts are generally unpopular, can be very costly, and can produce unintended negative consequences.) However some bubbles are so large and affect so many firms and individuals that there can be an overwhelming call for government-initiated bailouts.
The purpose of a “bailout” is to provide financial support to vulnerable firms and individuals until the normal market forces and government policies can restore the value of the underlying asset to a sustainable level. Ideally this is a level where normal economic activity can be sustained without depending upon the resources provided by the bailout.
A successful bailout would generally be considered one where the affected industry or individuals (or their successors) are once again economically self-sustaining, and the entity that provided the bailout has been paid back in full with an added premium payment for the risk that it took in providing the bailout.
By contrast, an unsuccessful bailout would be where the entity providing the bailout does not get paid back, or where the size of the required bailout expands to the point that the entity providing the bailout becomes at risk of being unable to meet all of its own financial obligations (which could lead to its own default or bankruptcy). In the case of an unsuccessful bailout, the entity providing the bailout may need its own bailout in order to survive.
The key to a successful bailout is to transfer much of the negative impact of a bursting bubble to a larger entity that can absorb the impact without risking its own economic well-being. One of the painful realities today is that the world is reeling from the effects of a thus-far unsuccessful bailout of the burst housing bubble that was financed by the central banks and sovereign governments of the world.
The bailout that helped soften the effect of the internet bubble bursting contributed to the formation of the real estate bubble. When the real estate bubble burst the only entities large enough to fund a bailout were the central banks and the national governments of countries around the world. Those bailouts have not as yet restored their respective economies to self-sustaining status. Furthermore the sovereign debt (debt incurred by governments) that many countries incurred to bailout the firms and individuals affected by the bursting of the real estate bubble has now created what some feel may be a sovereign debt bubble which could put the governments themselves in economic peril. The concern is that if there is a sovereign debt bubble (bubbles are always hard to detect until after they burst), it’s not clear what the “bigger entity” would be that could bail out the central banks and governments if it bursts.
3. How Could Such a Small Country as Greece Affect the Whole World?
Greece happens to be the first government in a developed country to face the very real prospect of defaulting on its sovereign debt obligations to the IMF in particular and to its other creditors in general. The question facing European policymakers is whether the Greek situation justifies a bailout that would involve the forgiveness of some portion of Greece’s sovereign debt. Greece is relatively small economically speaking, and there is ample reason to believe that the consequences of any default could be contained without spreading to other countries. On the other hand, if there is an international sovereign debt bubble and Greece is simply the tip of this fragile bubble, then a default by Greece (which would further reduce the value of their sovereign debt) could raise the prospect of reducing sovereign debt values of other distressed governments which could in turn quickly spread across the globe with no viable entity in the world big enough to provide an effective bailout.
Regardless of what happens with Greece, there will be a concerted international effort to minimize both the size of any Greek bailout and the impact of a potential Greek default. However if the Greek crisis results in the revaluation of the sovereign debt of other countries, it will likely require the creation of an unprecedented international central bank and sovereign government coalition to provide a bailout sufficient to contain the damage.
The IMF report released this past week basically concludes that the Greek government cannot recover economically without a substantial bailout including both additional funding from creditors combined with substantial forgiveness of current debt obligations. This IMF report is one of the first official acknowledgements that sovereign debt levels - even in developed countries - may have become unsustainably high. It raises the question of whether the value of sovereign debt for other countries may be valued at an unreasonably high (inflated) level (as was the Greek sovereign debt until recently).
With the outcome of the Greek referendum, the central banks and governments of the developed world will be working feverishly in the coming weeks to knit together an unprecedented roadmap for how governments caught in a sovereign debt crisis can effectively declare a form of bankruptcy in order to reduce their debt levels to a sustainable level. This is why the Greek debt crisis is a game-changing event for the world's economic institutions and why it is capturing the attention of financial policymakers everywhere. Forgiving any portion of the Greek sovereign debt will result in a review of sovereign debt valuations around the world, with the possible consequence that the market will revalue sovereign debt at a substantially lower level than is currently the case. Such a revaluation is what is often referred to as a bursting of a bubble.
If the Greece crisis results in lower valuations of the sovereign debt of other countries, a new international coalition of central banks and national governments may be required to assemble a bailout large enough to contain the resulting negative economic consequences.
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