

Greek Mythology: Deal Will Solve Debt Crisis

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European leaders worked out a deal in the wee hours in Brussels Thursday for a 50% haircut on Greek government debt, a leveraging of the European Financial Stability Facility to €1.4 trillion and a plan for the region's banks to raise new capital.

As has been the case with the previous grand schemes that were supposed to bring about a solution to European sovereign-debt crisis that boiled over more than a year-and-a-half ago, details of this latest deal, the most expansive yet, once again were sketchy. A 50% reduction in Greece's debt would mean a €100 billion cut, to 120% of that nation's gross domestic product, an unwieldy but not impossible burden.

All of which is roughly in line with the expectations of global financial markets, which have been lifted since Oct. 4 when broad outlines of a new debt deal first surfaced. As the risk of a disorderly default of Greek debt and a resulting collapse of European banks that Greece's main creditors subsided, risk markets such as equities have enjoyed a sharp rebound, much of which was based on covering of short positions.

But what should be realized is that the debt deals coming out of this latest summit of EU leaders was necessary to prevent a worsening of Europe's debt crisis, it is far from sufficient to address the region's economic woes.

The inescapable conundrum is that the austerity plans to attack the debt crisis will constrict economic growth. But growth is precisely what is needed to cure the debt crisis.

Historically, nations would escape this debt trap by devaluation. The real debt burden would be reduced by paying off obligations in depreciated currency, while competitiveness would be boosted by lowering export prices. Monetary policy would no longer be constrained by maintaining an exchange rate for the currency. Of course, the citizens of the devaluing nation would see their purchasing power reduced, but the devaluation would allow this adjustment to proceed, if not painlessly, then expeditiously. For this reason, most modern economists from followers of John Maynard Keynes to Milton Friedman prefer to let the currency's exchange rate to bear the burden of adjustment instead of the real economy.

That avenue is removed with the single currency in Europe. Greece was able to amass an unsustainable debt because of the market's willingness to buy its bonds at yields not far above the core economies of Germany or France because it couldn't devalue. Meanwhile, Greece's economy steadily lost competitiveness with the euro and couldn't compensate by letting the drachma fall, as in the days before the single currency.

With a fixed exchange rate, debtor nations such as Greece have to undergo the equivalent of an internal devaluation. More popularly, it's called austerity. Government benefits are cut and taxes are raised in order to reduce the debt. That works for a family but not for an entire economy. As everybody tightens their belts, the economy slows and falls into recession. Instead of shrinking, the government debt expands because of falling revenues.

In the case of Europe, the problem is compounded by the European Central Bank's refusal to adopt an expansionary monetary policy. Unlike the Federal Reserve, which is charged with the dual mandate to maximize employment and minimize inflation, the ECB's sole responsibility is price stability.

But that's resulted in too-tight policy on the part of the ECB, according to Michael T. Darda, chief economist and chief market strategist at MKM Partners. With a fixed exchange rate across the eurozone, economies in the periphery (such as Greece, Italy, Portugal and Spain) have become uncompetitive relative to the core in Germany. To restore competitiveness requires deflation -- without an easier ECB policy, he writes.

"The deflation of prices and wages in the periphery will make debt ratios worse, upend fiscal austerity efforts and will likely lead to serial defaults. In other words, it would spell the end of the eurozone as we know it. We can't be sure what the timeline is for this to take place, but our sense is weeks, months and perhaps quarters, but not years," Darda wrote. For that reason, he called the various measures such as haircuts on Greek debt, recapitalization of European banks and levering up the EFSF as rearranging "the deck chairs on the Titanic."

The main factor working against this outcome is that the ECB will see the error of its ways. It won't be swayed by cogent arguments such as Darda's. Neither will it be convinced by the quantitative easing undertaken by the Bank of England, which can run an independent monetary policy because of the U.K.'s decision to stay out of the euro.

More likely, the ECB will relent because of worsening social unrest as Europe falls into recession as a result of the fiscal austerity being forced on overly indebted nations. The riots and the petrol bombs seen in Athens could then become more prevalent across the Continent and make the Occupy Wall Street crowd look like happy campers.

Until that happens, the global markets are apt to applaud the latest European debt deal. Then they will have to deal with the slowing economies in the U.S. and China. One problem at a time.

Comments? E-mail: randall.forsyth@barrons.com