"Greece - The Chickens Have Come Home to Roost - A Lesson for the U.S."

Sydney M. Williams

Thought of the Day

“Greece – The Chickens Have Come Home to Roost – A Lesson for the U.S.”

April 8, 2010

Greece has been described, aptly it seems to me, as a slow motion train wreck. Predictably and reminiscent of Richard Fuld, Greek Prime Minister, George Papandreou, was quick to blame the crisis on “traders and speculators.”

The cost of insuring $10 million of Greek bonds against default for five years has risen from $124,000 at the end of 2009’s third quarter to $466,000 today. Any buyer of Greek bonds today, with any sense of prudence, would insure them against default. This means that if one were to buy $10 million 10-Year Greek bonds today and receive $710,000 in annual interest, he would have to pay out $466,000 for a net return of $244,000 or 2.4%. That does not appear an adequate return for tying one’s money up for ten years. Of course, if there were no CDS market, interest rates would be substantially higher.

Contrary to the complaints of politicians like Mr. Papandreou, the CDS market serves investors and governments well. Since the product is a form of insurance, it seems to me that it should be subject to insurance regulation and the insurers should be required to carry adequate reserves that are adjusted to reflect changing prices. But the product has a useful and economic role. A rise in the cost of insurance should serve as a warning signal to the company or country affected. Money and investments, except on rare occasions, are apolitical. They simply look at risk adjusted returns. Attempts to politicize or demonize these products will prove disastrous for investors or taxpayers, as well as for markets.

The Greek problem stems from social programs that were far too generous, in terms of entitlement programs – too early retirement, too generous benefits and inadequate reserves against future demands. Here in the U.S. we see those same problems. California pensions have assumed returns of 8%, a number almost four hundred basis points above Thirty-Year Treasuries, and a return substantially below ten year actual returns. A recent Stanford study indicated that if California used a more realistic discount rate of 4.7% (the current rate on Thirty-Year Treasuries), underfunding in their pension plans would rise by almost half a trillion dollars. Illinois has similar problems and so does the United States, as we continue to add entitlements that are inadequately funded.

Between 1966 and 2006, spending in the U.S. on Social Security, Medicare and Medicaid, as a percent of the federal budget, rose from 16% to 40%. At current rates, those three programs will, by 2050, consume 100% of the federal budget. Any rational person knows that the new Health Care entitlement will only add to the problem.

There are only two answers to this upcoming financial crisis – increase government revenues or spending cuts. There are only two methods to increase government revenues – raise taxes, or grow the economy. Since no government in recent memory has reduced spending, and such a possibility seems particularly alien to the current Administration, the answer will lie in raising revenues. Unfortunately, the two methods are usually at odds – higher taxes tend to inhibit growth. At some point, cutting spending has to be the answer. The coming home to roost of this problem can be seen visibly in Greece today, but it is a problem with widespread implications. As Governor Chris Christie is demonstrating, the answer must lie in cutting entitlements. The same will have to happen in Greece and, at some point, it will have to happen in Washington.

In the next few weeks the Greece Finance Minister, George Papaconstantinou, will do a road show in the U.S. attempting to sell bonds. There are about 1.1 million people of Greek origin living in the United States (about 10% of the population of Greece). Perhaps they should keep in mind an old saying, which dates to the Athenians when attacking Troy in c. 450 BC and their false gift of a wooden horse, beware of Greeks bearing gifts.