Lessons to Be Learned from the Greek Debt Crisis

The stock market slumped yesterday to a new 14-year low, while bond yields jumped toward modern-era highs. The currency also slumped, as politicians failed to enact deficit-reducing austerity measures.

Otherwise, nothing much of interest happened in Greece yesterday.

Here at home, the stock market rebounded a bit, as did the price of crude oil and most other commodities. Reuters News says the stock market advanced because of “Dell’s strong earnings” and that commodities rallied due to an “unexpected drop in US oil supplies.” Bloomberg News says the stock market advanced because “the Federal Reserve signaled continued low interest rates” and that commodities rallied due to “signs of increasing demand.”

The Daily Reckoning’s editors are not smart enough to know which specific event inspired the millions of separate transactions that lifted stock and commodity prices yesterday. We will leave that analysis to our counterparts at Reuters and Bloomberg.

That said, we will not refrain from tackling the tougher analytical tasks, like why investors are fleeing Greek stocks and bonds faster than a chambermaid flees an IMF Director’s hotel room.

Based on our exhaustive research, we conclude that investors prefer the securities of solvent entities over those of insolvent entities. But investors cannot always differentiate correctly between solvent and insolvent.

Early in a crisis, hope tends to trump fear. Investors tend to underestimate the underlying distress and overestimate the efficacy of exogenous remedies like government intervention. Early in 2007, for example, the US subprime mortgage market began melting down. By mid-summer, S&P was downgrading more than 600 mortgage-backed securities. And yet, investors bid the Dow Jones Industrial Average to record highs in October of that year.

Three months later, mortgage-lending titan, Countrywide Financial, collapsed into the arms of Bank of America. And two months after that, the Fed gave J.P. Morgan a sweetheart deal to buy the near-bankrupt Bear Stearns. Despite these growing signs of distress, most investors believed a crisis had been averted. But, of course, the crisis was just beginning.

A similar timeline appears to be playing out in the European Union, as we have noted in two previous editions of The Daily Reckoning. (See “The return of the Sovereign Debt Crisis” and “Trade of the Decade: Sell Everything”.) As Greece, then Portugal, then Ireland teetered on the brink of a sovereign default, the European Central Bank and the IMF rushed to the scene with a dessert tray of bailout goodies.

In May of last year, the ECB and IMF teamed up to send €110 billion ($137 billion) to the desperate Greeks. Ireland received an €85 billion ($113 billion) handout last November. And just this week, the European Union and the IMF agreed to send €78 billion ($115.5 billion) to Portugal.

Perhaps these rescue efforts will succeed, but we suspect they will merely forestall the inevitable. Greece will default…eventually. And now, finally, investors are beginning to imagine this possibility. As Greece’s financial distress becomes increasingly apparent, and her solutions decreasingly viable, investors flee.

The Price Trend of the Athens Composite Index Since Late 1997

Greek stocks just hit a new 14-year low today, as Greek bond yields remain near all-time highs. The Greek 10-year bond now yields more than 15%. That’s a great yield…if you believe you would actually receive it.

Greece’s deteriorating sovereign finances are emblematic of the Welfare State’s broken “business model.” The Greek government ran a deficit last year equal to more than 14% of GDP. A double-digit deficit seems certain again this year. These deficits will expand Greece’s total debt-to-GDP from about 125% today to numbers that are even more frightening for a bondholder. But these data points are only the beginning of this sad tale.

60% of Greeks don’t pay any income tax. Therefore, according to Eurostat, when you exclude social security contributions, Greece has the lowest tax revenue-to-GDP ratio in the euro zone, at 20.4%. Furthermore, Eurostat observes, “Revenues from personal income taxes…account for a mere 4.7% of GDP, compared with a [European] average of 8.1% of GDP.” Stated differently, personal income taxes contribute only 14.4% of Greece’s total tax receipts, compared to 43.2% of total tax receipts here in the US.

Bottom line: Even if Greece managed to triple its personal income tax revenue, its government would still operate in the red. Similarly, a doubling of all taxes on personal and corporate income would not close the budget gap. Something is very broken here.

Uncle Sam, are you watching?

Widespread sovereign insolvency, combined with the stench of decaying government finances, may not be immediately bearish for the financial markets, but we doubt they are bullish.

Eric Fry
for The Daily Reckoning