Greece Kills The Rule Of Law

Includes: BKF, FXE, GREK
by: The Credit Strategist

European authorities are patting themselves on the back for what they consider the success of the Greek restructuring, but the fallout from how the restructuring was achieved will reverberate for years. First and foremost, Greece will undoubtedly require further financial assistance from the European Union in the near future. The country's economy is deteriorating at an accelerating rate, and the austerity plans required by the bailout plan will only exacerbate its slide. As a result, Greece will be incapable of generating sufficient tax revenues to service even its remaining indebtedness. The terrible truth is that the country is caught in an economic death spiral to which only an exit from the European Union can put an end.

The second consequence of the most recent Greek bailout is that the rule of law in Europe has been abrogated in two ways. First, the invocation of the "collective action" clause in Greece's sovereign debt was a blatant breach of the contract between the Greek government and Greek bondholders. By retroactively inserting a provision in these debt contracts that forced private creditors into the debt restructuring who did not agree to the terms of the deal, the bailout introduced a new risk into all sovereign debt contracts. As Cumberland Advisors' David Kotok wrote: "No sovereign debt contract is now immune from the same action. All sovereign debt contracts will carry a risk a risk premium. Buyers of European sovereign debt now act at their own peril."

The rule of law was also trampled on by the European Central Bank's maneuver to treat their own holdings of sovereign debt better than those of other creditors. The ECB swapped its own Greek bonds for new Greek bonds that were not subject to the collective action clause, which has the effect of subordinating non-ECB holders to itself. By subordinating other holders of Greek sovereign debt to itself, the ECB effectively subordinated the holders of all European sovereign debt to itself. This will add to the risk premium on sovereign bonds and make it more expensive for countries to finance themselves. This was an extremely short-sighted move on the part of the ECB and further evidence of the damage done by bureaucrats who don't understand how markets operate in the real world.

The most serious consequence, however, is that investors should carefully study the reaction of financial markets as they initially rally in relief at the prospect that Greece will not default today and then drop again once they realize that Greece will require another bailout and so will Portugal and quite possibly Spain and other European sovereigns. Already the rally in Italian and Spanish sovereign bonds appears to have come to an end, although hope springs eternal. But the economic numbers emerging from the Iberian Peninsula are nothing short of horrific. Portugal cannot sustain itself much longer without outside assistance, and Spain is struggling to meet the requirements being set for it in Brussels. The European economy is deep in recession, and it will be much more difficult from the perspective of German domestic politics to approve a new round of financial support for Europe's weak southern countries. It is said that the definition of insanity is doing the same thing over and over again and expecting a different result. By that standard, Europe can proudly claim to be the birthplace of Sigmund Freud because it continues to pursue the same failed policy path with respect to its failing sovereign while compromising the rule of law in the process. One can only pray that the EU will find its way back to sanity before its current course lapses into tragedy or worse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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