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Euro debt crisis faces reality check

ALMOST three years of prevarication and sticking-plaster solutions to the European banking crisis look to have a date with reality over the next few weeks.

The Greeks cannot, or will not, pay back the enormous sovereign debt which has been contracted. This is the verdict of the markets, in which Greek sovereign debt trades at a huge discount and is now virtually uninsurable against default. Whether the Greeks cannot, or will not, meet the debt is irrelevant. The markets reckon the debts are not going to get repaid on schedule one way or the other, and have been unwilling to lend to Greece for over a year.

The deal in May 2010, a €110bn loan package from the EU and IMF, was too little given the scale of the Greek problems, and was criticised as inadequate at the time. In the year since, the Greek fiscal position has been revealed to be even worse than thought, and the Greek government has been dragging its heels on fiscal reform. But even if Greece had complied fully with the May 2010 deal, it would probably be coming apart around now because it did not address the core issue of solvency. Lending more to an insolvent entity, which commercial lenders will not touch, is an evasion rather than a solution. Greece needed debt relief in May 2010, not just liquidity. It also needed reform, and there appears to have been a serious failure of Greek political leadership.

Large amounts of Greek debt are held by Greek banks. You might be surprised to learn that banks are allowed by regulators to pretend that their holdings of government bonds, issued say for 10 or 20 years at 100, can be valued in the banks' books at 100, even if they have crashed in the market to 50 due to fears of default. The pretence is that the banks will hold them to maturity and get the 100 back eventually. This view is enshrined in regulators' rules and no heed is to be paid to market assessments to the contrary. Firms other than banks that persistently valued securities in their balance sheets at twice the market level would be in serious trouble with the authorities, and possibly with the police.

The ECB is also exposed to Greek government bonds, since it has taken vast quantities as collateral for loans to Greek banks. French banks are also big holders and several were downgraded by the ratings agencies last week as a result. So if there is debt relief for Greece, which means partial default on the bonds, the Greek banks would be bust, so would the ECB, and the large French banks would be in serious trouble. The notion the ECB could go bust should be a surprise, since normal central banks can print money, and never go bust. But the ECB is a most unusual central bank and has chosen to manage the European banking crisis without creating more money, unlike its Us and UK counterparts.

So the latest response to the Greek crisis seeks to acknowledge the need for debt relief, which should logically involve cutting the repayment to the market value of 50, while simultaneously maintaining the pretence that these bonds can continue to be valued at 100 by the banks which hold them, including the ECB.

This, in simple English, is the content of the spat between the French and German governments over the last few days about 'voluntary' haircuts for holders of Greek bonds. The markets, which value them at 50, are, of course, making a realistic judgement about Greece's economic and political capacity to pay. The EU and ECB are trying to solve a problem from Greek antiquity. Anaxagoras, according to Plutarch, first raised around 400 BC the problem of squaring the circle, and it should amuse all Greek citizens in these dark days to contemplate the remarkable sight of European politicians still wrestling with this ancient geometry puzzle.

To be clear, there is no way to reduce the debt in the Greek balance sheet without reducing equally the 'asset' in the books of Greece's creditors. The road down which the can has been kicked so vigorously has narrowed and the inventiveness of the can-kickers is facing a fresh challenge.

The best solution is always to acknowledge reality and fess up. The banks, pension funds, insurance companies and other holders of Greek sovereign and bank debt have already lost about half of what they chose to lend. These losses have already occurred. They are not created by doing the accounts properly.

It is profoundly dispiriting to observe the extraordinary wranglings these last few weeks about how this blunt reality can best be avoided through 'voluntary' private sector (means bondholder) bail-ins. The Franco-German leadership of the European project has been reduced to seeking the consent of troubled banks to the unavoidable relief of Greek debt. Banks will never 'voluntarily' write down assets without sweeteners, explicit or hidden. They have no visible incentive to acquiesce in anything other than a further pretence.

The slow-motion train wreck in Greece, predicted as well as predictable, was not the most significant development over the last few weeks. The continuing failure to address the eurozone crisis will face its Waterloo if Spain joins Greece, Ireland and Portugal in the club of potential defaulters.

Last week, the secondary market yield on Spanish government 10-year debt reached 5.7 per cent, ending the week a little lower. The Spanish treasury managed to sell some medium and long bonds at auction, but struggled to do so. If Spain goes under, the game is up and the world financial crisis will have had its second Lehman, this time under the tutelage of a eurozone leadership that has proven unequal to far smaller challenges.

Against this background, Finance Minister Michael Noonan spent the week in the US and drew some flak for revealing his intention to haircut some holders of senior bonds issued by two bust Irish banks, Anglo Irish and Irish Nationwide.

These two former banks have lost large multiples of their shareholder equity and if they were normal businesses, their bondholders would long since have written off 100 per cent of their unwise investments without a murmur. That Noonan's comments should have provoked any criticism at all is testament to the Alice-in-Wonderland of eurozone financial policy. There is never a wrong time to draw attention to the inevitable. The full payment of all Irish bank bondholders increases sharply the risk of sovereign default. An Irish default would magnify hugely the damage already wrought by the Greek train wreck and it is in Europe's interest to ensure that default is contained to Greece if at all possible. Noonan's stated intention to seek the imposition of losses on these unfortunate investors is good news for more deserving creditors in the queue, particularly holders of sovereign bonds. In a rational policy environment, Noonan's Bloomberg interview would have been welcomed as an overdue acknowledgement of reality and a stepping-stone to the resolution of the European banking crisis.

When huge losses have been incurred, the political task is to distribute those losses once and for all in a manner which permits economic recovery and maintains social order. Europe's current political leadership has decided to pretend that this task can be deferred indefinitely, or simply left to an ill-designed central bank and to volunteer patriots in the commercial banking community.

Writing in The Wall Street Journal during the week, two University of Chicago economists, John Cochrane and Anil Kashyap, summed up the challenge succinctly: "So what to do? Prepare for the worst. Europe needs to expunge the rot from its banks so that the inevitable write-downs do not imperil its financial system. Sovereign debt and sovereign exposure must face large capital buffers. Sovereign debt must be marked to market. Banks must run serious stress tests to find implicit sovereign exposure. Banks with inadequate capital must raise it, find buyers, or reorganise. If that means bailouts of 'systemically important' banks, then governments must do so, face their taxpayers, and make their regulators explain how they let this happen."

Something along these lines should, of course, have been done back in 2008. It is never too late to face policy problems honestly.

Colm McCarthy lectures in economics at UCD. He headed an expert group examining state assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua. He is also the author of the report into the semi-state sector from the Review Group on State Assets and Liabilities

Sunday Independent