Friday, June 27, 2014

Renewed Optimism About Greece Is Well Overdone

by Desmond Lachman

Real Clear Markets

June 27, 2014

Judging by the renewed optimism in the Greek sovereign debt market, one could be forgiven for thinking that the worst of the Greek economic crisis was behind us. After all, Greek sovereign bond yields have now declined toward levels last seen immediately before the onset of the European sovereign crisis some five years ago. However, it would be a grave mistake for Greek policymakers to allow currently buoyant market sentiment to blind them to Greece's still very large economic and political challenges. If left untreated, the country's poor fundamentals threaten to undermine Greece's prospects for digging itself out of its present depressed economic situation when global liquidity conditions become less favorable than they are today.

A popular adage on Wall Street is that when the winds are strong even turkeys fly. By this it is meant that when liquidity is ample, investors do not discriminate between different credits but rather invest blindly in anything that offers an attractive yield. If ever global liquidity conditions have been highly favorable, it has to have been in the past year and a half. For not only was the Federal Reserve expanding its balance sheet at an unprecedented rate but so too was the Bank of Japan in an effort to rid Japan of deflation.

In the context of ample global liquidity, Europe has now regained the market's favor despite the threat that a move to deflation poses towards the European economy and despite dismal European parliamentary election results, which suggested a crumbling of the European political center. As a result, the Italian government today can borrow at rates as low as those paid by the U.S. government despite the fact that Italy's debt to GDP ratio now exceeds 135 percent. Similarly, the French government now borrows at rates very similar to those of the German government despite the clearest of signs of domestic political fragmentation and despite the country's many structural economic difficulties. Meanwhile, countries like Cyprus and Portugal, which were not too long ago viewed as countries with unsustainable debt dynamics, have now been able to re-access the global capital market.


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