Wednesday, February 10, 2010

Will The EU Rescue Greece?

From the WSJ:

Germany is considering a plan with its European Union partners to offer Greece and other troubled euro-zone members loan guarantees in an effort to calm fears of a government default and prevent a widening of the credit woes, people familiar with the matter said.

The plan would be undertaken within the EU framework but led by Germany, one of the people said. German Finance Minister Wolfgang Schäuble has discussed the idea in recent days with European Central Bank President Jean-Claude Trichet, according to the person.

Mr. Schäuble told officials in Berlin on Monday that he had concluded there "was no alternative" to a rescue plan, according to a person familiar with his comments.

A meeting between the Mr. Schäuble and lawmakers on possible support for Greece took place Wednesday, and no decision on aid has been made yet, a finance ministry spokesman said. The comments come after Mr. Schäuble met with parliamentarians from the Christian Democratic Union and Christian Social Union, part of Chancellor Angela Merkel's center-right government, to discuss possible aid.

Once again, we revisit the issue of moral hazard in the market. This is an age-old question about how to handle situations like Greece. The reality is far grayer than we would like to admit.

First, let's consider the historical context of the Greek situation. Europe -- and the rest of the world -- is emerging from the worst recession in over 60 years. But the recovery is fragile. That means a sovereign default by any country could send the entire EU zone back into a recession. This makes the possibility of a rescue that much higher.

But there is something else to consider -- financial default at any time can lead to catastrophic results. For example, let's go back to Long Term Capital (LTC) in the late 1990s. The fear was LTC's collapse would spread out -- the result would be similar to dropping a large rock in a pond and watching the ripples emanate from the point of entry. This fear ultimately goes back to the Great Depression and the collapse of the Bank of the US (a private bank despite it's name) in 1929. The collapse of this bank lead to the first of three waves of bank failures in the US. Had the central bank stepped in the resulting crash may have been averted.

It's this situation -- one event beginning a toppling of the dominoes -- that keeps Central Bankers up at night. Yes, rescuing a bad actor does create a moral hazard. This in turn increases the possibility of further financial risk developing in the system which in turn increases stress in the system leading to the possibility of more bail-outs.

In short -- there are no easy answers.