Edward Hadas

Greece has come to the market again. It has successfully sold 5 billion euros ($6.7 billion) of seven-year paper at a yield of 6 percent, about 3.5 percentage points more than comparable German government debt. If politics were all that mattered, the new bonds would be a steal.

Greece clearly has political leverage over the European Union. Even Angela Merkel, the German chancellor who has been taking a hard line on helping Athens, does not want to countenance a default by a euro zone government. The International Monetary Fund is also interested in helping.

But ultimately, Greece has to make good on its existing 270 billion euros of government debt, not to mention the roughly 25 billion euros of new debt it is expected to raise in 2010. For that, the politicians need not merely a financial, but an  economic, work-out.  The constraints are daunting. On one side is the mountain of debt, set to rise to 125 percent of GDP this year. Yields on new paper are 3 percentage points higher than at the 2005 trough.

What’s more, about 70 percent of interest payments leave the country — so it’s not even as though Greece can tax the  recipients. On the other side is the precipice of falling GDP.  The government’s austerity plan involves cuts in spending and wages. The result is likely to be a steep recession, which would normally reduce tax revenue.

The most direct ways to get the debt level down — default and inflation — are all currently closed to Greece. That leaves  putting up taxes, further swingeing spending cuts and rapid growth as the main options.  The snag is that an even hairier fiscal shirt would militate against growth. And the easiest way of getting growth — a devaluation — isn’t an option.

For a country to stabilise its debt/GDP ratio, broadly speaking two things are needed. First, it has to stop running a so-called “primary deficit” — that is, the deficit before interest payments. Second, its average interest rate needs to be less than its nominal growth in GDP.

Both of these will be a challenge for Greece. Its primary deficit, 7.7 percent last year, is forecast to be not much under 5 percent despite the belt-tightening. Meanwhile, the average interest rate, currently 4.4 percent, will rise in the immediate future as the country issues bonds with 6 percent coupons.

What that means is that the economy really needs a period of  sustained nominal growth of 5 percent. Greece has enjoyed rapid growth in the past. Between 2000  and 2008 nominal GDP grew at a 7.3 percent compound rate. Butthe current yield reflects justified scepticism that it can get  back on the growth track.

The financial industry isn’t the only one that needs reform. The Federal Reserve, which if Senator Christopher Dodd has his way will get even more authority over the banking system, needs a transformation of its own. After all, the most senior U.S. financial watchdog missed one of the biggest credit bubbles since its founding.
But while action is called for, it’s not obvious what sort. After all, mindset, not the rulebook, was the Fed’s main weakness during the credit bubble. It had enough legal authority and political independence to fight against financial excess, but chose not to.
The politicians who are trying to redesign the national financial landscape can’t legislate a new intellectual paradigm, but they can try to avoid three pitfalls.
First, beware of the monolithic mindset. The 12 regional Federal Reserve Banks, each with its own traditions and expertise, provide a healthy check on groupthink in Washington and New York.
Second, don’t let politicians micro-meddle. The Fed needs political guidance on how to balance its objectives, but it’s healthy to have tension between a strong central bank favoring financial stability and elected office-holders primarily wanting happy voters.
Finally, beware of regulatory capture. As it stands, the two best-informed members of the board of the New York Fed are chief executives of giant financial companies: Jamie Dimon of JPMorgan and Jeffrey Immelt of General Electric. That creates unacceptable potential for conflicts of interest.
Mr. Dodd’s plan, unveiled on Monday, gets it mostly right. The regional Feds will stay, which is a plus. Bankers will be kicked off their boards. That’s good, but the plan goes too far by also banning all former bankers, whose expertise could be useful.
The plan goes wrong by making the New York Fed president a political appointment, just like the members of the Fed’s central board of governors. Politicians aren’t ideal judges of who has the technical expertise needed to sit at the center of the financial markets.
Still, one more political appointment might not be too high a price to pay for a generally sensible reworking.

Birthdays are a good time to look back. The first anniversary of the global stock market rally — the lows were hit on March 9, 2009 — certainly brings back memories. It’s easy to see why the MSCI World Index  is 71 percent higher now than then.

Then there was a steep recession, now there is GDP growth. Then it was realistic to worry about such horrors as rapid deflation, serial banking crises and a competitive protectionism. All of those menaces have now receded. And stock market investors can be cheered to see companies sufficiently in control of their short-term destiny for most of them to meet or beat analyst expectations of reported profits.

But this birthday celebration is no better than bittersweet. The stock market rally has spluttered somewhat. While the UK’s commodity-heavy FTSE 100 index is hitting new highs, most others have made almost no progress for five months. That stalling reflects both an unexpectedly tepid economic recovery and serious worries about whether there will be much to celebrate on future birthdays of the 2009 stock market trough.

Too many of the wounds of the financial crisis remain unhealed. Central banks are still extraordinarily generous and unemployment rates remains unacceptably high. The world remains too leveraged for its own good. And while the financial system is no longer in crisis, its newfound ebullience is itself a cause for worry.

The new talk of inflation is a sign of how far from health markets are. Stock markets are ultimately good hedges against rising prices, but investors feel queasy when economists at serious institutions such as the International Monetary Fund, Morgan Stanley and Societe Generale see high inflation as either the most likely or the least bad way to erode excessive leverage.

Historically, a great 12 months in the stock market has usually been followed by a mediocre period — an average 3 percent decline since 1940 in the United States, according to Deutsche Bank. Stock markets are still well below their peak levels, but there may not be much to celebrate this time next year.

Currency buyers are suffering from King Lear’s dilemma. Shakespeare’s monarch could not decide which of his two ungrateful daughters was less awful. What looked like a bad deal from one, permission to stay with 50 knights, suddenly seemed attractive when her sister’s alternative was a mere 25.

Trading floors may not echo with Lear’s desperate words — “when others are more wicked, not being the worst stands in some rank of praise” — but foreign-exchange dealers know the feeling.

Only a few weeks ago, they were mostly worrying that the mix of huge U.S. fiscal deficits, political gridlock and tepid economic recovery would undermine the dollar. The euro, by comparison, looked less awful. The region’s sluggish recovery and expensive currency in terms of relative prices were offset by a positive trade balance and signs of fiscal discipline.

But then the woes in Greece and other weak euro zone members came to the fore. FX traders began listening to the euro-sceptics who had long been predicting the single currency would split. Big bets were placed against the euro, while the United States, for all its long-term weaknesses, looked a safer place to spend a few weeks.

Lear had only two wicked daughters, Goneril and Regan. But there are more ugly sisters in the currency world. The pound still counts as a major currency, though maybe not for long if fears of a fiscal crisis — think huge deficits and a hung parliament in the upcoming election — become self-fulfilling. Since Feb. 15, sterling has fallen 2 percent against the weak euro.

For now, the yen could most resemble Cordelia, Lear’s virtuous daughter. Japan, however, seems locked in permanent recession and some currency gurus say the over-indebted government will inevitably meet a disastrous end.

King Lear eventually was driven to madness by his “unkind daughters”. Currency traders generally welcome the volatility generated by rotating fears. It would be foolish to assume the worst news will continue to come out of Athens. There are enough problems around the world that the euro’s time as the ugliest princess is likely to be brief.