Politicians in Europe are playing a dangerous game

The Greek debt crisis could easily be defused and is in fact in the economic interest of each and every country in the European Union. But politicians, especially those in Germany, are playing a dangerous game…
Some history
After some fiscal retrenchment (and some cooking of books, like in Greece), countries like Greece, Portugal, Italy and Spain were allowed to enter the European Monetary Union (EMU) that many had serious doubts about. The benefits for these countries were rather dramatic.

  • Overnight, the risk of a currency devaluation disappeared, sharing the same currency with the likes of Germany and France.
  • Overnight, their weaker financial reputation and track record didn’t matter, enjoying the same inflation fighting central bank with the likes of Germany and France.

The effects of these were rather dramatic as well. Interest rate differentials disappeared at the short-end (where central banks set the rates) and narrowed to insignificant amounts at the long-end. This drastic reduction in interest rate fuelled a spending boom in private and public sector alike, reinforced by an influx of foreign capital as a result of the disappearance of the devaluation risk.

For a time, the likes of Spain (mainly through a housing bubble), Ireland (real estate and finance) experienced tremendous economic growth and even the likes of Greece and Portugal performed a bit better than before (only Italy maintained the same sluggish economic performance).

But this boom sawed the seeds of its own destruction. Inflation differentials became wider, and accumulating these over time deteriorated competitiveness. As long as the economies continued to perform not many people worried about that, but then came the financial crisis and the world recession.

Ireland was especially hard hit because its growth pillars (real estate and finance) were both in the eye of the storm. But Ireland was also the one to most forcefully react to the new environment, with a drastic public sector retrenchment involving public sector wage cuts up to 20%.

The old structural problems in Spain (and to a lesser extent, Italy) once more came to light when the Spanish housing boom turned to bust and the rest of the economy and especially its labour market

Greece simply turned out to having cooked it’s books on a really stunning scale (admitting a year or so ago that its public sector deficit was at least twice as large as previously reported).

Come the financial crisis
The the economic crisis and the stimulus measures to counter it, and the loss of competitiveness as a result of accumulated inflation differentials with the rest of the euro zone really set public sector finance on unsustainable paths. Of course markets started to sniff that out and began speculating against the debt itself, and the insurance instruments on the public debt (credit default swaps, or CDS’s).

At the minimum, this exacerbated the crisis and at the worst this is threatening to create the type of self-fulfilling prophesy that financial markets are so good at creating because as the insurance on the debt increased in price, more institutions were forced to sell the debt, increasing the interest rates and making the insurance against default ever more expensive.

Greece is merely the first manifestation of this because its public finances are so spectacularly mismanaged and because a lot of debt matures rather soon (in May).

How could the Greek crisis be defused?
Simple. The European Union (with or without the help of the IMF) guarantees a standby credit of a sufficient size (compared to the figures we’re used to in the financial crisis, this is even rather small fry, say $20B euros maximum) at a guaranteed interest rate (some points over Germany’s).

And hey presto, the crisis would dissolve. Market rates on Greece would come down and with a little luck Greece wouldn’t even need to draw on that emergency credit.

If it’s so easy, then why hasn’t it happened?
Two reasons:

  1. Moral hazard
  2. Politics

1) Moral hazard
Many argue bailing out Greece would reward bad behaviour. Indeed, Greece’s public finances are a mess and the books were cooked in a rather spectacular fashion for quite some time. But does Europe have a choice? We don’t think so.
The same moral hazard argument was used against bailing-out financial institutions (and the car industry). If bad behaviour leads to shifting the cost on others, the disincentive for it will weaken. Just like the high-rollers within financial institutions that engaged in risky bets with other people’s money because they had little to loose and lots to win, politicians within the euro zone could play Santa and shift the cost to next generations and the European Union at large. If bad behaviour is to be stopped, it’s got to have bad consequences.

However, just as the financial institutions were too big to fail, Europe can ill afford to let Greece go down the drains. French banks own a cool $800B in public debt of the weaker eurozone countries (the ‘PIGS’s’, Portugal, Italy, Greece, Spain, sometimes Ireland is also added although that country really has embarked on a most spectacular fiscal entrenchment). Germany owns $500B of that.

Letting Greece default would trigger a financial crisis part II. This cannot happen. The interests of the bankers and the politicians seem to be aligned. Or does it?

2) Politics
Understandably, Germans feel little enthusiasm bailing out the Greek. Jokes even appeared in the popular German press that Greece could easily sell off a few islands (they have rather a lot) to fulfil its obligations. From the above, a simple solution seems to force itself, letting the German politicians reframe the issue as (a rather cheap) rescue operation to prevent their banks from tumbling, since they own so much Greek (and other “PIGS”) debt.

But of course, bankers were never really popular in Germany after following the Anglo-Saxon model in the last two decades or so (and leaving their long-term relation banking of their ‘Rheinland’ tradition behind), and even less so after the financial crisis. So this is no vote winner either.

If you were mystified by Angela Merkel (the German Chancellor) seemingly irreconcilable positions of having to explain (on the international stage) that Europe would support Greece (but being rather scarce with the details) but on the domestic scene promising that no German tax money would be spent on bailing out Greece, perhaps now you understand.

The hope was that a mere European solidarity announcement and the semblance of a rescue plan would do enough to calm the markets and bring interest rate differentials with German bunds down. The hope was that no actual financial support would be needed.

But that’s clearly not working.

It was already humiliating enough that the European plan involved the IMF (a bad sign that Europe is unable to deal with their own problems, even for a rather small country as Greece). Now the Greek prime minister Papandreou is going on a road show to the US to interest US funds for Greek dollar dominated bonds. A euro member issuing bonds in US dollars. It can hardly be more humiliating.

So here is where leadership is required. We think ultimately the Germans will swallow the bitter pill and agree make funds available for Greece at a substantial discount to the present very high market rates (borrowing at 7%+ clearly isn’t sustainable). At present, they have only agreed to to this at a slight discount to the market rates, but since that, these rates have gone up rather alarmingly, so this clearly hasn’t worked. 

We think the immediate crisis can, and ultimately will be resolved. Germany itself (that is, German banks) stand too much to lose, the risk of contagion to the rest of euro members with precariously weak public sector finance is too high.

But whether the Greek public sector financial position is on a sustainable path even then is far from assured.

Leaving the euro?
Having to increase taxes and drastically curtail public sector spending in the middle of a recession clearly doesn’t help the economy. There is something to be said for leaving the euro and reintroduce their own money. An immediate devaluation would at least restore competitiveness.

It’s way easier to change one price than to change all, Greece will have to go to a prolonged period of deflation to restore its lost competitiveness vis-à-vis the rest of the eurozone, deflation which will only exacerbate its debt situation. Depending on whether, and if so, how they re-price the debt in the (new) drachme, it could also aleviate the debt situation (which would be outright theft, but the type of theft history is littered with).

On the other hand, one can only imagine what panic such a step would bring (already there are small runs on Greek banks), and the huge rise in interest rates one can expect in order to keep at least some money in the country). Europe won’t allow it as it would risk the break-up of the whole monetary system (apart from destroying decades of investing in credibility of financial institutions and arrangements, not to speak of the whole European Union). So we can’t see Greece leaving the euro anytime soon either.

Sunny as these islands usually are, their prospects have distinctly dimmed. And the same can be said for much of the south of Europe (the Club Med countries; Greece, Portugal, Italy, Spain). Joining the euro has been something of a mixed blessing. They had a chance and they mostly wasted it.

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