Archive for July, 2011

The least one can say is that the EU Ministers meeting in Brussels yesterday (21 July 11) at last took decisions to avert immediate crisis as the Vox EU letter from 13 economists asked.^[1] Although it is early days yet, the package seems to have been accepted by the markets. The aim of the exercise was only in part to bail out Greece—chiefly it was meant to halt an attack on Italy and Spain. And it appears to have worked since yields on 10-year bonds in both countries have fallen and the euro has strengthened against the dollar. ^[2]

As for the decisions, let’s look at them in turn. The most striking, of course, was the approval of the €109bn Greek bailout subject to the condition that the private banks ‘share the pain’. The Germans have insisted—having brushed aside the objections of the ECB and a variety of (mainly French) counter-proposals—that private banks are to be offered a ‘voluntary’ choice of bond exchanges, buybacks and rollovers. Without going into precise details, because banks don’t generally value their bond assets by ‘marking to market’, this means taking a haircut of 10-15%. The catch is that Greek banks hold the bulk of the bonds—far more than France and Germany combined—so their banks will suffer most. ^[3]

The gamble is that even if the credit rating agencies mark down Greek bonds to selective default grade, either the ECB will ‘make an exception’ and continue accepting these bonds as collateral, or else the agencies will immediately rescind their markdown as soon as Greek debt in re-profiled. The meeting did add that there would be no haircuts on any non-Greek bond. Mrs Merkel and her team wanted a warning shot fired across the private banks’ bows about ‘moral hazard’, but the conditions are such that Greece’s selective default seems unlikely to provoke another Lehman moment. ^[4]

Will Greece now prosper? Cutting the interest rate on the EU/IMF package to 3.5% and extending the loan, as well as many of the short-maturing term bonds, to 15 years certainly makes the debt more manageable, as does the promise of more structural funds from the budget and the EIB to help kick-start growth. But claiming that this constitutes a ‘Marshall Plan’ is decidedly over-the-top, especially since the country is currently plunged into economic contraction worse than it experienced after the 2008 shock. In the absence of nominal exchange rate adjustment, Greece must continue to apply the wage-cutting ‘internal devaluation’ medicine, a cure which could still kill the patient. Moreover, if the country’s debt-to-GDP ratio is to fall in future, it must grow fast enough to generate a primary budget surplus.

Turning to the wider picture, while the strengthening of the European Financial Stability Facility (EFSF) is to be welcomed—its size will be doubled to €800bn, it will be able to lend pre-emptively anywhere in the Euro Area (EA) and some have even suggested that it will be a European mini-IMF—questions still remain. The most obvious question concerns size. The ESFS needs far more capital to be truly credible, a total of €1.5-2.0tn.^[5] It will not get all this from the member-states, implying that sooner or later it will have to borrow on international markets; ie, it will need to issue some form of European euro-bond.

But the most worrying feature of the package is its conditionality. The centre-right German, Dutch and other governments are revising the zombified Stability and Growth Pact (SGP) by passing legislation forcing all other EA countries to return to a 3% general budget ceiling by 2013. As Paul Krugman promptly tweeted—comparing the EU to the US in 1937—budgetary austerity is the last thing Europe needs at the moment. ^[6]   To add to the pain, the ECB has raised its key interest rate again. Business confidence in the EA has ebbed, with the eurozone PMI falling to its lowest level since 2009.  Like Britain, the EA needs reflation, growth and jobs—not prolonged fiscal austerity.

In sum, there is a short term gain—assuming the ‘haircut’ strategy works, a major euro crisis has been averted and a strengthened EFSF (to be made permanent and rechristened the European Stability Mechanism after 2013) is emerging, an embryonic institution strengthening EA economic governance. But if it is to withstand bad weather in countries such as Spain and Italy, it will need far more capital. Europe is still without a central bank that can trade genuinely European bonds and engage in Open Market Operations; it is without a Treasury or a long-term macro vision of how to overcome its trade imbalances.^[7] In the medium-to-long term, bigger decisions need to be made to avoid even more serious pain.

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^[1]  See http://www.voxeu.org/index.php?q=node/6778

^[2]  See http://online.wsj.com/article/BT-CO-20110713-705779.html

^[3] See http://www.cnbc.com/id/43850798

^[4] See http://bit.ly/ntPCyX

^[5] The Dutch Central Bank says at least €1.5tn will be needed; see In Traynor, The Guardian 22 Jul 2011; http://bit.ly/qbfvrT

^[6] See http://krugman.blogs.nytimes.com/2011/07/21/1937-1937-1937/

^[7] See Irvin and Izurieta, ‘Fundamental flaws in the European project’ Economic and Political Weekly, http://epw.in/uploads/articles/16386.pdf

It should now be obvious to all that the Greek bailout is not about saving Greece. It is about squeezing the country enough to make sure a number of large EU banks who hold Greek debt (and an even larger number of banks that have lent money to them) don’t go broke.

Until recently, many northern Europeans appeared to believe that Greece had been living beyond its means and therefore needed to tighten their belts—just as most Brits appear still to believe that Britain faces such a fate. But has austerity helped Greece pay its way? Not at all; austerity has only made things worse. Before the crash of 2007-08, Greek GDP was growing at 4.5% per annum. Mainly as a result of the draconian programme of cuts imposed by the EU/IMF last year, Greek GDP has fallen 8.5% since early 2010. Moreover the burden of the cuts has fallen not on the rich (who don’t pay their taxes) but on the poor (who can’t avoid them).

As Martin Wolf recently reported, when last year’s cuts were announced, the spread between German and Greek bonds was about 460 basis points (4.6%). It is now 1460 basic points.^[1] In effect, Greece has been locked out of the world’s private financial market. The country’s debt-to-GDP ratio is now 160% and rising.

The Greek Parliament has now effectively approved the latest €28bn austerity package demanded by the EU/IMF in order for them to disburse an extra €12bn in funding which Greece needs to get through the next month without defaulting. But this package is so deeply unpopular that it seems unlikely to be fully implemented. As protesters are now chanting on the streets: “First they robbed us, now they have sold us.” Even if it were fully implemented, the package would merely deepen the Greek recession making it even less likely that the debt-to-GDP ratio will fall.^[2]

Nor does the latest French ‘Brady-bond’ proposal really fit the bill? While lengthening the maturity on Greek debt to 20-30 years and establishing a fund to guarantee its repayment may be a good idea in principle, there are several problems with the plan. First, it covers only a relatively small proportion of Greek sovereign debt; secondly, it is unlikely to satisfy the private banks (Deutsche Bank has already criticised it) and, most important, even if accepted ‘voluntarily by the banks, the rating agencies may still consider Greece to be in default.^[3]

Is there any way out? Basically, there are two possible paths.

The first scenario is for the EU/IMF to keep pouring money into Greece, in essence buying time for private banks to reduce and write off their debts. Once this is done—and assuming ordinary Greeks will accept being squeezed for several more years—Greece will be allowed to default. The problem here is twofold. First, will the speed with which the ECB, the IMF and the ESF (European Stability Facility, which starts working in 2013) buy up debt be enough to prevent a Greek political meltdown. Remember that if the Papandreou government falls, the opposition leader Mr Samaras has said he will reject EU/IMF conditionality. The second problem is that outright default might lead to Greece leaving the euro. A return to a (rapidly falling) drachma would leave the country facing high inflation, falling real wages, and an even higher debt mountain.

There is another possible outcome—although it would require an astonishing U-turn on the part of the EU/IMF. The alternative is for all or most of Greek sovereign debt to be ‘forgiven’ (it is unpayable anyway); for the German, French (and Greek) banks to be recapitalised; and for Greece to receive enough assistance to bring its social and economic infrastructure up to a level which would help ‘crowd in’ private investment and restore its economy to health. This is the ‘Marshall Plan’ scenario, if you will. Such a plan could be financed by E-bond emission (Mr Juncker’s proposal), by ECB quantitative easing or by a Tobin tax (or some combination of the three); thus, the ‘cost to the European taxpayer’ could be negligible.

I can hear the reader object that pigs are more likely to fly supersonically. But the longer the EU/IMF continues along its current foolish path, the greater the chance of a second major financial catastrophe engulfing not just Greece but much of Europe.

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[1] See Martin Wolf ‘Time for common sense on Greece’ Financial Times, 21 June 2011.

^[2] See http://www.citywire.co.uk/money/rob-kyprianou-greece-votes-for-austerity-what-happens-next/a504630?ref=citywire-money-latest-news-list

[3] See P Jenkins and R Milne ‘EU “Brady bonds” plan for Greece’ Financial Times, 27 June 2011.