Greek Debt Was a Two-Way Deal
By Philippe Gastonne - July 07, 2015

GREEK cities were filled Sunday night with cheering supporters of the victorious Oxi ("No") camp in the referendum on the bail-out terms demanded by the country's European creditors. Many believed they had launched an anti-austerity revolution that would soon sweep the rest of Europe.

In the rest of Europe, such a revolution did not seem to be on the way. Across southern Europe and in France, where demonstrators had rallied in Paris to support the "No" vote, some sympathised with Greece's plea for solidarity; but others wondered why the Greeks feel entitled to special treatment.

Meanwhile, in Germany and northern Europe, the "No" vote seemed only to have reinforced the conviction that Greece should be left to its fate. As Angela Merkel, Germany's chancellor, and François Hollande, France's president, prepared to meet Monday evening to discuss offering Greece one more chance, their countries were split by the divide. – The Economist, July 6, 2015

News stories about the Greek crisis constantly return to a familiar refrain. The country's politicians and citizens alike borrowed unwisely, spent too freely and now don't want to pay their debts.

This impression isn't wrong, but it misses half the story. Loans are always two-way transactions. One party lends and the other one borrows. Both sides take risks and both sides receive benefits.

Lenders know – or should know – that it is always possible the borrower could default. They are supposed to assess that risk and lend only at interest rates that compensate them for taking it. Portfolio managers who hold many loans should diversify to minimize the risk of unmanageable simultaneous defaults.

This means defaults should not bother well-prepared lenders. They know the risks, factor them into the interest rates they demand, and realize that occasional mistakes are inevitable.

Greece's lenders were not well prepared. They ignored the risks, didn't demand market interest rates, failed to diversify and presumed mistakes were impossible.

The fact that Greece had a spendthrift government with several defaults in the past was no secret. Anyone paying attention knew a decade ago about Greece's widespread tax evasion, overly generous pension schemes and already excessive debt load. Yet they kept on lending.

This decision looks very unwise in hindsight. The big banks were the first to realize it and successfully transferred most of their obligations to Eurozone governments. Now those governments are on the hook for someone else's bad lending decision.

Europe would not now be in political crisis if it had left those loans in private hands where they belonged. Germany and its allies surely know this; it probably explains their evident frustration. Taking further debt write-downs might be the wisest business decision, but it is unacceptable for politicians who must face re-election.

Greece clearly went over its head in debt, but it did so with the knowing cooperation of its lenders. For those lenders to demand Greece now bear the full consequence of the joint mistake is intolerable on the Greek side. Hence, we have the current standoff.

No one knows how this will end. There is plenty of pain to go around. If history is any guide, those who created Europe's monetary union will now push for an even tighter union. Greece's "no" vote suggests they will not want to join it.

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