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
