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Academic

: The Faculty Lounge

The Modern Greek Drama, Part 2

By Dan Filler, Laura Appleman et al.

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<o:p></o:p><a href="http://blurblawg.typepad.com/.a/6a00e54f871a9c88330120a8383167970b-popup" onclick="window.open( this.href, '_blank', 'width=640,height=480,scrollbars=no,resizable=no,toolbar=no,directories=no,location=no,menubar=no,status=no,left=0,top=0' ); return false" style="float: right;"><img alt="Gulatim" class="asset asset-image at-xid-6a00e54f871a9c88330120a8383167970b " src="http://blurblawg.typepad.com/.a/6a00e54f871a9c88330120a8383167970b-500wi" style="margin: 0px 0px 5px 5px;" /></a> In my last post, <a href="http://www.thefacultylounge.org/2010/01/the-modern-greek-drama-comedy-tragedy-or-both.html">The Modern Greek Drama: Comedy, Tragedy, or Both?</a>, I offered the insights of Cleary Gottlieb Steen & Hamilton partner and sovereign debt guru, <a href="http://www.cgsh.com/lawyers/bio.aspx?lawyer=f2725186-db47-4cae-a4a0-eb5b8a23fd7a">Lee Buchheit</a>, on the current Greek sovereign debt drama. In this post, Buchheit's frequent co-author, Duke law professor <a href="http://www.law.duke.edu/fac/gulati/">Mitu Gulati</a>, discusses his reactions. The spectre of a string of sovereign defaults -- remember the drama over the Dubai World default some months ago -- is back again. It was the scare over Dubai that appeared to get the markets to ask whether there were other economies that might produce surprise defaults. Attention moved from the usual suspects in regions like Latin America to the previously unthinkable members of the European Union. Specifically, to Greece (and maybe now also to Italy and Spain). Risk premiums increased and serious scrutiny was put on Greece's finances in particular. A couple of months later, the markets do not like what the heightened scrutiny has revealed (the words "book cooking" or their equivalent show up frequently, see <a href="http://www.economist.com/blogs/charlemagne/2010/01/greek_bailout_within_months">Charlemagne's notebook</a> in The Economist.). <o:p> </o:p> But what precisely is going on? Do sophisticated investors seriously think that Greece will be allowed to default? Won't the IMF or the European Union be sure to bail them out? After all, a default in Greece would present the risk of spillover effects into its European compatriots. And some of those other European nations appear not to be in the best of fiscal conditions (read, Italy and Spain) and others (like the U.K.) are very much hoping to be climbing out of a painful recession. <o:p> </o:p> In theory, there is a constraint on a Eurozone bailout. The Lisbon Treaty imposes a "no bailout" provision. I am no expert on European treaties, but am guessing that one of the functions of this clause is to provide a protection against moral hazard. In relevant part (see <a href="http://blogs.ft.com/brusselsblog/2010/01/eu-possesses-the-legal-power-to-rescue-greece-if-necessary/">Tony Barber's FT blog</a> post from last week), the Lisbon Treaty says that assistance is permitted if a Eurozone member "is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council [of national governments], on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the member-state concerned." That clause is probably supposed to function as a commitment device. It tells the more profligate among the European spenders that the more austere nations (think Germany) will not come to their rescue even though the failure to rescue has the potential to cause harm to the entire Eurozone community. <o:p> </o:p> Well, the rubber seems to have met the road, and the question is whether anyone will take the "no bailout" clause seriously. If the clause were taken seriously, there would be no bailout because financial profligacy (along with a dose of book cooking) are probably precisely the circumstances under which the commitment against bailouts was supposed to operate. In other words, not the "exceptional circumstances" contemplated by the treaty. The question though is whether the political flesh will be weak (as it usually is) and whether, so long as Greece makes some efforts in the direction of showing that it is serious about austerity, a bailout will be in the offing. Many experts seem to think that the inconvenient clause will either be explained away or just ignored. If so, that should lead us to ask: Does anyone take moral hazard seriously anymore? Or have the pundits decided that the costs of moral hazard are not that high? <o:p> </o:p> -- Mitu Gulati <o:p> </o:p> Much like bad luck, great blog posts on sovereign debt crises come in threes. Stay tuned tomorrow for an upcoming post from <a href="http://www.wcl.american.edu/faculty/agelpern/">Anna Gelpern</a>, Associate Professor of Law at American University, who'll add her views to the mix. Related posts: <a href="http://www.thefacultylounge.org/2010/01/the-modern-greek-drama-comedy-tragedy-or-both.html">The Modern Greek Drama: Comedy, Tragedy, or Both?</a> (Reactions from Lee Buchheit) <a href="http://www.thefacultylounge.org/2010/02/verge-of-the-unb%C3%B6ring-the-modern-greek-drama-part-3.html">Verge of the Unb ring (The Modern Greek Drama, Part 3</a>) (Reactions from Anna Gelpern)

Full post as published by The Faculty Lounge on February 05, 2010 (boomark / email).