The Sovereign Debt Waterfall Part 1 - Greece

   The nature of the debt problem in many countries of the world can be compared to canoes on a fast moving river, approaching a waterfall. In this analogy, Greece is the lead canoe, now dangling on the edge of the waterfall. The United States is three years away from the waterfall, I would guess. Closer to the waterfall are Portugal, Ireland, Spain and Italy. Japan is also closer to the waterfall, but seems to be approaching it in asymptotic fashion. France and German are six and eight years away from the waterfall, but are attempting to throw ropes to the European nations closer to the edge, and may thereby get  to the edge before the U.S. China is on the river somewhere, but its finances are sufficiently opaque as to make it hard to tell where. Israel used to be close to the edge, but has moved upstream and now passed Germany going the other direction. South Korea is a rare model of fiscal discipline which can be said to be not on the river at all. Iceland is an example of a country that jumped out of its canoe and let it go over the edge. This article, part 1 in a series, will focus on Greece.
   Greece is on the edge of the waterfall, half way off and half way on. Greece had smooth cruising until they reached the waterfall in April 2010. Normally, a country could not stay on the edge of the waterfall so long, but Greece is a special case because it was first, and it is small enough to be bailed out for as long as the European Nations have the will to do so. That may not be much longer, but in theory Greece is small enough that it could go on for a long time. No one else will stay on the edge but for a short time. The European Union has not forgiven Greek debt or let them default, but instead has extended additional loans (which cannot be paid) on conditions that Greece takes austerity measures sufficient to reduce its deficit. But when one is on the edge of the waterfall, it doesn't matter how hard you paddle in reverse, you are still going over.
   Here are some of the financial conditions in Greece. First, their one year treasury bond pays 183% on the open market, as of today (October 25, 2011). Now 183% is not a realistic interest rate for an investment - if it was we should sell our homes and buy Greek treasury bonds. The 183% is instead a gamble on how long Greece will last before reneging on their debt, or until someone decides they will pay only 40 cents on the dollar, or something like that. Furthermore, the 183% is the open market rate, not the rate the Greek government will pay when it issues new treasury notes next month. Next month (unless things fall apart before then), Greece will sell new notes for a very low rate, which no one would normally buy, but they will be bought using the bailout money provided earlier by the other members of the European Union. This is instructive for when the U.S. reaches the edge of the waterfall. The market will spike our interest rates too, but no one will bail us out - we are too big. Our government then will not be able to issue new debt, because we will not be willing to pay 183% interest or anything approaching that. What this means is that when we reach the edge, the government will not participate in further deficit spending. If we think it would be tough to not raise the debt ceiling now, well, the day will come when we no longer raise it due to market conditions.
   Second, Greece is going through stringent austerity measures to try to get its deficit down to a manageable level. They won't make it, but they can go through the agony of trying. This has led to major layoffs, cuts in government services, etc. The austerity program has driven Greece deep into recession. Thus it will do to everyone who reaches the edge of the waterfall.
   Third, consider Greek pensions. If they are like pension plans in most countries, like Social Security in the U.S., they are heavily invested in Greek treasury notes. If those notes do decide to pay 40 cents on the dollar, then that means Greek pensions will take a 60% cut.
   This is how things look on the edge of the waterfall. Greece has not yet gone over the edge. That will be the subject of a later article.