Greece deal highlights the euro's design flaws
The Eurogroup summit failed to give the Greek economy a realistic lifeline, and failed to bring stability to the listing eurozone
Published 19/07/2015 | 02:30
The negotiations about Greece should have had two objectives - to give Greece a shot at economic recovery, and to avoid Grexit and further destabilisation of the common currency. Neither objective has been achieved.
The outcome of the Eurogroup summit last weekend has not moved Greece closer to an end to reliance on official lenders. The economic situation remains dire. It has, however, illuminated the design flaws in the eurozone which gave rise to the Greek crisis in 2010, and has reminded everyone that these design flaws have not been fixed. It has also created new risks for heavily-indebted eurozone members.
When states lose access to the sovereign debt markets, they can no longer run budget deficits nor can they replace historic borrowings as they fall due. In the absence of non-market support, they would be forced into immediate and possibly destructive fiscal correction. The objective of official lending programmes, as provided to countries around the world by the IMF, has been to return them as quickly as possible to credit-worthiness and hence market access, without severe contraction. The 2010 Greek 'rescue' was meant to return Greece to the markets without any need for further support after 2013. A second programme means that the first programme failed and a third programme means that the second one failed too.
The third Greek programme remains to be negotiated in detail. It will be implemented against the background of an economy which is contracting again, banks closed for business and requiring re-capitalisation, and a government with debts of 180pc of GDP already in default to the IMF.
The summit communique released on Monday has the following features:
Ω No early recapitalisation or even reopening of the banking system;
Ω A renewed and front-loaded fiscal contraction;
Ω No write-down of state debt.
Commentators have already warned that a programme along these lines will likely see GDP in Greece fail to stabilise and possibly continue to contract, with the budget heading back into serious deficit. They identify a high degree of risk that the third programme for Greece will also fail, perhaps quickly.
The communique lists a series of reform measures, some of which could assist economic recovery in the longer term. None of them is likely to have sufficient effect inside the programme horizon to offset the negative impact of new expenditure cuts and tax increases.
When a state loses access to credit, substitute (which means official) sources of finance must be found or there must be default.
The eurozone 'no bailout' clause thus logically entails that a member state in trouble can turn only to the IMF, and the IMF often insists on default to those who financed the initial excess. The abandonment of the no bailout clause on the occasion of the first Greek crisis in late 2009 and early 2010 was motivated by fears of contagion: default would have adversely impacted German, and more particularly French, financial institutions, which had large Greek exposures and were already fragile. Had Greece been deemed insolvent and permitted to default, there would have been costs for the German and French (and some other) treasuries in rescuing the institutions placed in danger. Instead, Europe and the IMF lent the money, creditors got paid and the debts were transferred to the Greek state. As with the Irish banks, the party rescued by the first Greek bailout was the creditor of the failed institution.
Economists at the IMF had reservations about Greek debt sustainability in 2010 but unfortunately they failed to persuade the political leadership to haircut holders of Greek sovereign debt. Greece's debts are now mainly to official lenders, they are again excessive and the IMF has returned to its principles and threatened not to participate in Bailout 3.
The detailed design of the third Greek programme, if one is agreed, would need to respect some simple principles if it is to offer a realistic chance of success. In particular, it should be focused on meeting the conditions for the state's re-entry to the private debt markets within a short time span, say three years. This needs debt-servicing burdens to be reduced, including headline debt figures, if that is what markets worry about. And it needs a resumption of economic growth at the earliest possible date. This in turn requires the avoidance of excessive front-end loading of fiscal correction and sufficient time to achieve reform targets, for example the reduction of corruption in the public administration system and enhanced tax collection. Some of these reform targets may take very considerable time and it is not realistic to include them in programme conditionality.
If the programme does not respect these principles, it will fail, and failure could emerge quickly given the weakness of the Greek economy and the evident political instability.
A striking feature of the discussion last Sunday was the explicit threat of Greek suspension from the eurozone, the first time such a threat was made to any member. The implication is that failure of whatever programme is agreed will see a renewed threat of Grexit.
It is difficult to see how the Greek banks can recover their deposit base, even when recapitalised, while this threat remains. The specific formulation (a five-year 'time-out' from the euro, an utterly impractical procedure) was unimportant: the point is that Germany sought to make membership of the common currency conditional. The fact that this conditionality did not survive into the summit communique does not matter either. The irrevocability of the currency union has been qualified in negotiations with a debtor member. Thus the summit has failed to remove the threat of Grexit, if that was indeed one of its objectives.
Fundamental flaws in the eurozone design have not been addressed, in particular banking union. The closure of the Greek banks as a direct result of ECB action has highlighted once again that the measures taken to date have failed to break the 'vicious circle' between banks and sovereigns. The closure of these banks, now supervised by the ECB, was occasioned precisely by concerns about the sovereign, not about the banks.
The threat of expulsion from the eurozone is rendered credible, whatever the legal niceties, by the willingness of the ECB to act in this manner. The next indebted country to get into difficulties will accordingly suffer a bank run earlier, and in greater volume, than might otherwise have been the case. If that country happens to be Italy or Spain or France, the common currency would become irretrievable and a managed break-up would follow, doubtless at great cost. But if the next casualty is a small country, the example of Greece suggests that the country would be deemed expendable. It accordingly makes sense for the small indebted countries to take all feasible measures, in particular an early return to budget surplus and intense prudential supervision of banks, in order to reduce the exposure to a Greek experience.
It always makes sense to plan for adverse scenarios. While they may deny it, every finance ministry in the eurozone has been planning for the possibility that the common currency experiment ends badly, an outcome rendered more likely by the serial failures in Greece.