Markets appear to have already decided the recent package for Greece does not work and is not credible. It is not very rigorous to infer much from a couple of trading days, but the magnitude of the market movement together with the debate on the matter let us infer its failure. The package does not seem to work towards the set objectives of calming markets and limit contagion. It does not seem credible, as per the yields of the long-term Greek bonds still pointing to insolvency.

A rescue package that is 50% of an insolvent country’s GDP is bound to create more problems than those it solves. Europe (more accurately, Germany and the IMF) has made a fundamental mistake, which might cost dearly. The capital flow towards the US economy is bound to exacerbate, leading to lower interest rates, which benefits growth and the fiscal stance in that country. This is why we have just eliminated all equity exposure to Europe in our portfolios (there was only a small indirect exposure through the S&P100 Global index). In the short-term, concerns about the integrity and stability of the euro itself should generate volatility across markets, which is why we are working through portfolio rebalancing along this line. In the medium-term, the relevant phenomenon is capital reallocation towards the US and the countries with better fiscal positions (especially those in emerging markets).

Bailout packages make sense when they address transitory liquidity problems, providing a bridge towards a sustainable path. This is the basic premise behind IMF-like institutions. But countries with unsustainable fiscal positions require excessive help for too long (potentially permanently), which in itself is unsustainable. This is when debt restructuring it the solution. In Greece, there is a debt sustainability issue together with other imbalances difficult to address because of the euro.

The set of countries where markets smell trouble seem to mix those with liquidity and solvency issues. Some countries seem to have a transitory liquidity problem, while others seem clearly unsustainable if analyzed from a historical objective angle. Not many people argue that Greece is not part of the second group, making its debt restructuring a very likely medium-term scenario.

Europe has committed the credibility of the union rescuing Greece in this fashion, while violating its own young constitution. The required fiscal adjustment is without precedent for a country like Greece.

One can argue that Europe has moved reluctantly, only to minimize contagion and the size of the overall problem. The issue is that those other countries can run into liquidity troubles, but are less likely to have such a severe solvency problem. Greece’s package damages the credibility of the EU and the euro, making the policy response to those liquidity problems more cumbersome (Portugal, Ireland, Spain, etc.). This debate leads directly to one about the value and sustainability of the institutions underlying the euro.

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