As the EMU bloc stagggers towards a messy deal on Greek debt this week, it is worth thinking afresh whether the present strategy of “kicking the can down the road” still has anything to commend it. Increasingly, the chosen route of procrastination and obfuscation looks like the worst of all possible worlds. Instead of buying time, which was the original intention, the strategy is maximising the risk of a disorderly blow-up which would do much greater damage than the intrinsic scale of the original problem should merit.
The hallmark of Europe’s response to the debt crisis has been a refusal to admit openly to the loss of solvency which has occurred. Every intervention so far has pretended that the crisis is one of liquidity, which can be solved by making loans to the troubled banks and governments in question.
This has had certain short term advantages. Since, in theory, there has been no permanent transfer of fiscal resources from the core to the periphery, the strategy has been just about acceptable to the electorates of the creditor nations. And since there has been no open admission of default or debt restructuring by any of the troubled nations, the banking sector has not been forced to write down debt and raise more capital.
If this gamble worked, it might delay a final resolution of the problem to a time when it could be more easily absorbed in the European banking sector. Delaying tactics of this sort have worked before, in periods after severe financial shocks.
However, the strategy requires that fiscal austerity in troubled economies eventually eliminates primary deficits, so that markets recognise a return to solvency, and become willing once more to fund the banks and public debt of the troubled economies. This triggers a virtuous cycle, with yield spreads declining, and budget arithmetic improving still further.
None of this was impossible, but it certainly does not seem to happening, especially in the case of Greece. Instead, the austerity measures which the Greek government still seems determined to pursue are proving so painful that parts of the population are now in open revolt against the entire strategy.
It is conceivable that Greek politics could lurch in a direction which involves a disorderly repudiation of public debt, and even a last-resort departure from the euro. Although some people are arguing that the Argentinian default a decade ago prepared the ground for improved economic performance in that country, it is very hard to imagine how a disorderly Greek default today could work to the advantage of Greece, the core European nations, or the financial markets. More likely, everyone would lose.
Furthermore, it is not as if the current European approach is avoiding a build-up of debt, and an eventual fiscal transfer, from the strong countries to the weak. A list of the main creditors to Greece is now topped by the European Central Bank, the European Financial Stability Facility (EFSF), and the IMF. Especially in the case of the ECB, what were initially termed liquidity support operations have rapidly turned into semi-permanent transfers of resources from one economy to another.
Nouriel Roubini has called this “fiscal union by stealth”. Perhaps it is politically more feasible than a more open approach, because it is not sufficiently understood by the public, and because it still might one day, under increasingly implausible scenarios, be partially reversed. But the financial markets can do simple arithmetic (sometimes!) so the crisis is not moving towards any sort of resolution.
It is a matter of logic that the economic losses which will ultimately follow from the sovereign debt crisis must fall on some mixture of the following parties: the people and tax payers of the indebted economies via budgetary austerity; the private sector holders of the sovereign debt, mostly in the European banking sector; the taxpayers in core European countries, like Germany, via fiscal transfers; and the citizens of the Eurozone as a whole, in the form of an inflation tax which would follow monetisation by the ECB.
At present, there is an attempt to impose most of the losses on the people of the GIPS. While this may appear to be a just and proper outcome to the electorates of the creditor nations, it also might not work. The Wall Street Journal asked the question last week “what happens if the Greeks do not want to be rescued?” That, it seems from recent events, is rapidly becoming much more than just a hypothetical question.
All of this might still be the best approach to take, if there were no better alternatives available. But there are.
A co-ordinated and determined resolution process could be announced by Germany and France. This would need to include one or both of the following ingredients. The first would involve a Brady-type plan for the restructuring of the Greek public debt, swapping new par Greek bonds for the bonds currently in issue. The new bonds would be longer in duration and the existing ones, and would carry lower interest rates, so there would be implied losses for private sector bond holders to accept. But since the new bonds would carry the same face value as the old ones, there would be no immediate write-down of banks’ capital.
A second ingredient could be a larger issuance of EFSF debt which would be used to purchase Greek bonds in the marketplace. Yes, that would involve a fiscal transfer. But that is exactly what is happening already. An orderly plan would probably involve a further fiscal transfer which is no bigger than the one which will happen ayway under the present strategy, but it would replace the current risky cocktail with a programme of much greater order and control.
At present, the strong economies are making ever-increasing fiscal transfers to the weak, without resolving the crisis. The Greek crisis should be a storm in a tea cup, not a global financial melt-down.
