Greece’s Default Crucial to Defending Euro

Published on February 22, 2010

Greece must be allowed to default on its debt, for the benefit of the Euro, said John Cochrane, AQR Capital Management Professor of Finance. “In this case, the story really matters because we are setting vital expectations for how this arrangement is going to work in the future,” Cochrane said during a Myron Scholes Global Market Forum, sponsored by the Initiative on Global Markets, at Harper Center on February 22.

“Default is not a danger to the Euro,” he added. “In fact, Greece’s default is crucial to defending the Euro. There is nothing vaguely contagious or systemic about this. Greece is not a complex brokerage interconnected with 150 million derivatives contracts. This is a sovereign debt they can’t pay back. The result is that people are going to lose some money. Those who bought that debt without buying insurance wanted to earn the premium and bet on the idea they were going to get bailed out.”

The potential contagion effect of a Greek default, said Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and David G. Booth Faculty Fellow, is via expectations. “The moment Greece defaults,” Zingales said. “The default premium on other weaker European countries will increase, which will almost automatically force some of this country to default, as well. Take Italy, for example. It has been hit harder by the recession than the United States, and it has a debt that is 120 percent of its GDP. So far, this has limited the budget deficit to ‘only’ 5 percent, but if the borrowing cost were to shoot up, its position could easily unravel. Allowing these failures might be the right thing to do, but the consequences are going to be fairly devastating in terms of the Euro and the European economy.”

In large part, Greece and Italy joined the European Union to benefit from low interest rates, he said. “The moment this interest rate disappears, the political benefit to stay within the Euro becomes much smaller,” Zingales said, “since Italy and Greece have lost in competiveness since the joined the Euro. They cannot keep up on a level playing field with Germany. They have to adjust or face major devaluation, and I don’t see those adjustments coming.”

The essence of the problem is moral hazard, said Roger Myerson, Glen A. Lloyd Distinguished Service Professor of Economics at the College. “The Greek crisis is a subtle conceptual problem that sharpens our understanding of many things,” Myerson said. “This includes joining the European Union to get some of its confederate reputation, which enables you to sell your debt more cheaply, and now you’ve got a temptation to sell more debt.”

The International Monetary Fund should develop a sub-national lending entity to finesse its relationship with the EU and to view the Greek crisis as an opportunity to help, he said. “This is what the IMF does with sovereign debt,” Myerson said. “It helps prevent bank runs on sovereign nations by addressing the auditing problem and throwing in amounts of its own limited, valuable resources.”

Some of the ideas discussed by the panelists might be applied to similar situations in other places in the future, said José Rodriguez, a first-year student in the Full-Time MBA Program. “Everyone is very interested in what’s going in Greece,” Rodriguez said. “The panel gave us a better sense of the overall environment. I agreed with the idea that the problem is one of moral hazard and with some of their recommendations on how to deal with it. We’ll just have to wait and see what happens going forward.”

--Phil Rockrohr