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Time the good boys play hard ball

THE resignation of Juergen Stark from the European Central Bank executive board last Friday is further evidence of the policy divisions in Europe. The rift between Germany and the ECB concerns the ECB policy of buying government bonds in the secondary market, and another German Bundesbank president, Axel Weber, quit the governing council in February last over the same issue.

If the ECB were to cease buying Italian bonds, in response to foot-dragging by Italy over budget reforms, the interest rates faced by Italy would rise steeply and force Italy out of the bond market, joining Greece, Ireland and Portugal in a bailout programme. The trouble is that Italy is too big to accommodate within the lending resources available to the EU and IMF.

Meanwhile, the second bailout for Greece, agreed (or apparently agreed) on July 21 has yet to be finalised and there is open speculation of an imminent Greek sovereign default, or even of a Greek exit from the eurozone.

A crisis postponed can resolve itself gently if policymakers are lucky. But a crisis can also intensify and get resolved rapidly in disorderly fashion. The European banking and sovereign debt crisis has not been contained, and the prospects of a sudden endgame, involving sovereign defaults or even a fracturing of the common currency zone, have been rising.

Currency unions can break up in a disorderly fashion. The rouble zone broke up in the early 1990s, essentially because the Bank of Russia lost control over money-creation by regional central banks in former soviet republics such as Ukraine.

One by one, and after some colossal bouts of inflation, the new states introduced their own currencies, and Russia had the rouble to itself by 1995. What goes around comes around: one of these republics, Estonia, is the most recent recruit to the eurozone!

The European Central Bank has wisely retained greater control than did the Bank of Russia, so what happened to the rouble could not happen to the euro. But the odds against some kind of euro break-up have shortened, particularly because of the problems in Greece and the market perception that the Greek crisis has still not been credibly addressed. There have been two Greek 'rescue' packages, in May 2010 and in July 2011. Greece will have been rescued only when the markets are willing to lend money to the Greek government at affordable rates.

The two 'rescue' packages were not designed to rescue Greece in this sense, and have not done so. During the week, yields on Greek two-year debt exceeded 50 per cent and Greek government bonds are virtually uninsurable against default.

The markets have concluded that the Greek authorities are unable, and the European authorities unwilling, to deal decisively with the Greek crisis. The EU/ECB/IMF troika departed Athens suddenly last Friday week, as the Greek willingness to implement the terms of the second bailout appeared to weaken.

Introducing his 2012 budget in the Bundestag last Tuesday, Germany's finance minister Wolfgang Schauble warned the Greeks that failure to agree the renewed austerity programme would result in funds being withheld. Greece cannot borrow anywhere else, and a withholding of troika funds would mean early default on Greek sovereign debt, as well as government inability to meet its weekly pay and social welfare bills.

The endgame is approaching for Greece and a severe haircut for holders of sovereign debt appears inevitable. This should have been done in May 2010.

Most observers thought the first Greek bailout deal would be insufficient, but sovereign default was not contemplated at that time, for fear of destabilising the European sovereign debt market. The extend-and-pretend policy has destabilised that market anyway, and an early resolution in Greece might have done less damage.

Even though no formal mechanism for a country to leave the euro has been provided, it appears that the Greeks could be hung out to dry and there is open speculation in Germany about a possible Greek departure. Speculation even extends to an improbable two-speed system with a 'hard-euro' for Germany and its satellites, with Mediterranean Europe consigned to a 'soft-euro' zone.

Unfortunately, the deep thought being devoted to these matters is coming about 15 years too late. The eurozone was always a political project, and the monetary system was incomplete from the beginning, with no centralised bank supervision or resolution structures in place, no proper central surveillance of credit policies or budgets and no decisive lender-of-last-resort for either banks or governments.

This incomplete system might have worked if there had been voluntary adherence to prudent budget and banking policies and no great external shocks. But the 2008 credit crunch emanating from the US found the European banks in fragile condition, many government budgets over-extended and European institutions poorly designed for crisis management. Add in the absence of political consensus on the policy response, and the flaws in the design of the common currency have been cruelly exposed.

Some countries should perhaps have never been allowed to join, and some others, including Ireland, might have been wiser to wait and see, as did Denmark and Sweden. Last Thursday, writing in the Financial Times, the Dutch finance minister advocated treaty changes which would provide for expulsion of eurozone miscreants in future. But in the here and now it is not possible to retrofit a mechanism for countries to leave in an orderly fashion.

The old currencies have been abolished and cannot be summoned back to life over a weekend. Nor can debt contracts denominated in euro be transformed into obligations in some new, and presumably less attractive, currency that did not exist at the time the debt contracts were entered into. Citizens of Greece who hold assets in the form of euro would be loath to see them transferred into an inferior currency. Unscrambling this particular omelette back into its constituent eggs is an impossible task.

But a Greek sovereign default need not require Greek departure from the eurozone. It would have serious consequences for other countries in the firing line, however. A severe haircut on Greek sovereign debt (if Greece were a Latin American country, the IMF would be recommending 50 per cent or more) would cripple its own banks and damage numerous others in Europe which hold Greek debt.

Thankfully, this does not include Irish banks, but there would be further pressures on sovereign bond markets in countries like Ireland and Portugal as well as heightened concerns about Italy and Spain. A less likely, but not impossible, scenario is a disorderly ejection of Greece from the eurozone, which could happen if the European Central Bank allowed the Greek banking system to go under. Bloomberg reported last Friday that: "Chancellor Angela Merkel's government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.

"The emergency plan involves measures to help banks and insurers that face a possible 50 per cent loss on their Greek bonds if the next tranche of Greece's bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government's bank-rescue fund introduced in 2008 might be enrolled to help recapitalise the banks, one of the people said."

The Irish authorities will be spared any new worries about the recently re-capitalised Irish banks, which have no exposure to Greece, but a Greek default could reverse the improvement in Irish bond yields. This, though, is a minor matter -- Ireland is out of the bond market for the time being, perhaps for several years, and what matters most is reducing the budget deficit quickly and reducing the bill for payoffs to bondholders in Anglo and other banks.

Finance Minister Michael Noonan has rightly raised again the question of further payouts to these bondholders. Anglo and Irish Nationwide are being closed down, they no longer have deposits, they do not lend. They are deceased. Their shareholders have been wiped out. Both of these banks have lost, not just their capital, but large multiples of their capital. No government would compensate bondholders in bust banks which have effectively been closed down, except under duress.

In Ireland's case, the duress has come, remarkably, from our European 'partners' who have sought consistently to protect creditors in these banks at the expense of those who hold Ireland's sovereign bonds and of course of Irish taxpayers. Ministers should be vocal in drawing attention to this fiasco and should exploit whatever opportunities arise as the endgame unfolds.

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, An Bord Snip Nua. He also authored the report into the semi-state sector from the Review Group on State Assets and Liability.

Sunday Independent