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By Jeremy Glaser | 04-29-2010 05:27 AM

The Looming Sovereign Debt Crisis

Professor John Cochrane thinks the fiscal crises in California and Illinois are similar to those in Europe and could lead to inflation in the United States.

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Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm here today at the University of Chicago Booth School of Business Management Conference. And I'm here to talk with Professor John Cochrane about the Greek sovereign debt crisis and what it could mean for domestic investors. Professor Cochrane, thanks for talking with me today.

John Cochrane: It's a pleasure.

Glaser: In your key note earlier today, you mentioned a little bit about that Greek might be the Bear Sterns of the sovereign debt crisis. Could you talk a little bit about what worries you about the Greek sovereign debt?

Cochrane: Well, as with the last crisis, I worry that bailing out Greece means everybody will assume that then the Germans, French, and IMF will bail out Spain, Portugal and so on and so forth.

As the bailouts get bigger and bigger, sooner or later there's a point where you can't bail-out anymore and then the crisis is much bigger than if you had let the first one go. So, I think they ought to let Greece, if not default, at least restructure. That would be much healthier for the Euro. That would be much healthier to get us out of this bailout mentality.

Glaser: Will there be an impact on the Euro if Greece were to default?

Cochrane: I've talked to a lot of people about this and opinions differ. In my view over the long run, this is absolutely necessary to save the Euro. So, over the long run, moving the Euro to a system where individual countries can default is the only way to keep it from turning into inflation.

In the short run, there'll be some chaos. So the Euro could go up or down where it's depending on what traders do about the short run.

Glaser: Is there any way that Greece could exit the Euro or the Eurozone, then, could force Greece or some of the other weaker members out?

Cochrane: There are ways in which it could do it, but it's so impractical that I don't think it would help. In addition, exiting the Euro would be the same thing as defaulting. Because Greek debt says, "I will pay you 100 Euros." Well, if they say, "No, no, we're going to pay you 100 Drachmas." That is a default. So leaving the Euro wouldn't do them much good right now.

Glaser: You mentioned inflation as being one of the potential consequences, is that something that we could see spill over into the United States?

Cochrane: Yes, because we're facing our own looming sovereign debt crisis. California looks a lot like Greece. Illinois looks a lot like Portugal. I think, no matter what they say, our federal government will be surely tempted to bail those out rather than let them, actually default.

Our own deficits are already characterized by the administration as unsustainable. So, sooner or later, the US can run out of its ability to borrow money and then we're in a horrible mess.

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