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The Wrong Medicine

Greece's problem is solvency, not liquidity...

THINGS JUST keep getting worse in Greece. And frankly, it's hard to see how they won't get worse still before they get better. The Greek economy is growing slower than the International Monetary Fund and the European Central Bank (ECB) and the government expected. Lower than expected growth makes it hard to grow your way out of debt, writes Dan Denning in his Daily Reckoning Australia.

And even restructuring is no guarantee. You can extend maturities on debt. But you still have to make interest payments on it. And with interest rates rising, debt servicing payments are an even bigger drag on the needed recovery.

Woe is Greece! And don't think the Spanish, the Irish, and the Portuguese aren't watching to see what happens. Raising taxes will not be popular (and it also cuts growth). But the ECB is dead set against restructuring. Why? It reckons that Greek private banks would be rendered insolvent if they were forced to take a haircut on their holdings of government debt.

Ah yes! A whole banking system capitalized by government debt is a problem...when the government can't realistically pay its debts. In the private sector, you could convert the debt to equity. Bondholders, faced with getting nothing at all or an equity stake, could be forced to accept a new arrangement. But now that Europe's debt quandary has moved from the private sector to the public sector, turning public debt into equity isn't as easy.

In moments of vexation like this, our thoughts often turn to our old economic mentor, the late great Dr. Kurt Richebacher. Kurt never called himself an Austrian economist. But he did subscribe to at least one tenet of the Austrian Theory of the Business Cycle: mal-investments made during a credit boom must be liquidated in order for the cycle to bottom and growth to begin again.

Everything that's happened in Europe and China and America and Australia since 2007 has been designed to prevent a reckoning: the liquidation of bad investments made during the credit boom. This would result in massive write downs in the value of credits and assets like stocks and bonds and residential and commercial real estate.

To avoid that, record liquidity in the form of bank reserves has been added to the system. This has floated asset prices (mostly stocks) higher. But banks – the Australian lenders excepted – have been reluctant to lend. The additional liquidity hasn't resulted in real economic growth. However it has resulted in record levels of speculation in financial markets, especially commodities.

Yep. We hate to say it. But even though several years have passed since the bursting of the credit bubble in the private sector, the problem hasn't been resolved. It's been made worse. And it's never been a liquidity problem. It's a solvency problem. The public sector in many of the Welfare States simply has liabilities it can never hope to meet.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

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