Greece’s Managed Default

Feb 21, 2012 at 10:52 am

Forgive me if I’m just being rhetorical here, but it looks to me like all the headlines about how the latest bailout of Greece enables the country to avoid default have it wrong.  Greece is defaulting on its sovereign debt, and that’s a good, as in “necessary,” thing.

When the terms of a loan are restructured such that the lender accepts less favorable terms—they “take a haircut” on principal, the interest rate, the maturity of the loan—that’s a type of managed default associated with the renegotiation of the original debt contract.  In the course of these negotiations, holders of Greek bonds will need to take 50-70% haircuts (crewcuts?)—that’s some serious restructuring.

Think GM/Chrysler vs Lehman Bros.  Both were defaults but the former was “managed” and it…um…worked out a bit better than the latter. 

I also think the distinction is important—and not just rhetorical—re the necessity point made above.  One of the keys to diagnosing type of crisis right is to recognize whether you’re looking at an illiquidity problem or an insolvency one.  The former, arguably the US case, leads you to pump liquidity into the system holding the non-performing assets (the banks, in our case) until normal credit operations can resume.  The latter should lead you to rip the band-aid off and force some haircuts.  That would be Greece.

To get this wrong—to misdiagnose insolvency as illiquidity—risks pumping resources (liquidity) into a black hole.  It’s bailing out a boat with buckets much smaller than the hole in the floor.

Perhaps gentler language here helps to calm markets or something, and I’m not sure it makes a big difference at the end of the day.  Neither am I saying that the plan will work—skeptics abound.  But words mean something, and this looks like a managed default to me.

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