Ok, maybe I need a better title to this post. Maybe a straightforward one would be, “Why The U.S. Should Be Concerned About the Situation in Greece”.
It is a complicated matter, but it comes down to the fact that European Union and U.S. debt are interlinked through the banking system. The Greek economy isn’t big enough to matter that much – in 2010, it was in the low to mid 30’s in country rank of GDP and purchasing power. The problem is that Italy, Portugal, Spain, and Ireland (and probably others down the road) are in a similar situation to Greece, so how the Greek situation proceeds will likely set a precedent (or a warning) to these other countries. The EU governments, by and large, have promised to their citizens more social programs than can be financed with the tax revenue generated by the private sector – something that should sound eerily familiar here in the United States. Greek governments have run chronic budget deficits for decades, and the Greek banks lent to the government to fund these deficits. This continued even after Greece joined the EU in 2000, even though Greece was expected to start complying with EU deficit parameters by getting its public spending under control. To make things worse, banks in other EU countries (e.g., France and Germany) started lending to Greek banks. In Greece and elsewhere in the EU, the banks support the government by purchasing its bonds, and the government guarantees the banks.
Right about here is where the red lights should be flashing in your head and the name Bernie Madoff should come to mind. The parallels with why he went to prison (rightfully so) and how the EU banks can no longer afford to fund budget deficits but they also can’t afford to see governments default should be clear. And governments are so strapped they can’t make good on their guarantees of the banks. Details differ by country. For example, Ireland’s situation was driven by an overheated real estate sector that brought down its banks, and France has a growth problem while its public sector commitments have remained largely in place. Every time President Sarkozy tries to cut back, the French go on strike. Germany is the only strong large economy in the EU right now, but its banks have some potentially nasty exposure to EU member-country defaults.
And here is where the United States comes in. American banks and other financial institutions are exposed to EU banks through funding operations, issuance of credit default swaps, and unknown exposure to the derivatives markets. Our Federal Reserve even does currency swaps with the European Central Bank. The ECB deposits euros or euro-denominated assets with the Fed, receives dollars in return, and is on the hook to repay the Fed in dollars plus interest. The question is, in a crisis situation (like what happened in 2008), what exactly is the Fed’s counter-party exposure if neither the EU banks nor the ECB can secure enough dollars in global markets to repay the Fed? Remember, unlike the Fed, the ECB can print euros but it can’t print dollars. Therefore, no one seems to know exactly what the full risk to the Fed is, and losses on the Fed’s balance sheet get laid at the feet of, the American taxpayer, not EU citizens. It is likely that the International Monetary Fund (IMF) will almost certainly be involved in any bailout scenario if (when?) Greece defaults as a nation. As a point of reference, the U.S. funded about 17% of IMF operations.
These “gifts” are not the ones we want from the EU but we’re going to get stuck footing the bill.
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