At the beginning of 2010 it became clear that Greek public debt was becoming unsustainable. Greece could no longer borrow from the international bond markets.
If, at the time, Greece had defaulted with a 30 per cent or greater ‘haircut’ (loss) imposed on bondholders, Greek debt would have become sustainable in the long run. The country would have had to borrow internally, perhaps issue IOUs (as it has done already) and impose a few modest cuts. The effect of such a policy would have been mildly recessionary.
What was done instead by the EU/IMF/ECB ‘troika’ was to provide Greece with loans so as to cover its budget deficit without default, in exchange for increasingly draconian budget cuts, tax increases and institutional changes of dubious value. Existing bondholders continued to have their interest and maturing principal fully paid.
The effect of this policy has been a fast downward spiral of the economy. Since debt keeps increasing and the country keeps getting poorer fast, debt is becoming ever less sustainable. The debt-to-GDP ratio went from 115 to 160 per cent in less than two years.
Even the German Chancellor recognized that this charade cannot continue.
Greece cannot be allowed to default. There is no such thing as an ‘orderly’ Greek default, as some have called for. All the banks would collapse, an incredible hardship on everyday Greeks, whose current social upheaval would intensify. Future Greek debt would find no buyers globally except at usurious rates. Effectively, Greece would no longer be able to borrow the funds that sustain anything remotely like its people’s current way of life.
Arguably worse, leading banks elsewhere, notably in Germany, London and New York, would suffer huge losses on their holdings of sovereign euro debt that would destabilize state finances for governments across the continent and in Britain obliged to bail out these ‘systemically critical’ lenders.
The German Chancellor isn’t exaggerating about the ‘Lehman effect’ of a Greek default, a reference to the global financial meltdown following the September 2008 collapse of New York investment bank Lehman Brothers Holdings Inc. To invoke a hoary Cold War term, there is a domino effect to consider here: if the eurozone allows one country to default, what confidence can global bond buyers have in the debt of other troubled euro-economies?
The argument that last year’s first effort at a Greek bailout was bungled is valid. So was the Irish bailout. In each case, the bailout loans bore unmanageably high interest rates; and Greece was implored to engage in harsh austerity at impractical speed. But then, euro leaders repeatedly accused of sloth in responding to the crisis have been dealing with an unprecedented event. The eurozone is just a dozen years old, and its architects made no plans for coping with defaults they did not anticipate.
Thus the rescue has been a work in progress. The larger European Union’s survival without a eurozone is doubtful. The biggest losers in that event would be the major economies, whose robust trade with their neighbours has seen Europe eclipse the US in economic size. Not coincidentally, the EU’s tenure has marked the longest period of uninterrupted peace in European history. There is too much at stake to allow any eurozone member nation to default.
If default of a small country in the eurozone, amounting to 2.7 per cent of its GDP, threatens to blow up the world’s financial system along with the eurozone, then there is something seriously wrong with both the financial system and the eurozone
I recognize that the blow-up scenario is serious. In that case, if trillions of losses can be expected, giving 180 billion euros in grants to Greece to pay off half of its debt would solve the problem. This will not be done, not because it can’t be done but because, even if Greece did not exist, there would be Portugal, Ireland, Spain, Italy and other countries that pose the same threat, with only a time difference.
The problem is dual: the financial system was not fixed after 2008 and the eurozone has no hope of functioning without political unification. Thus an orderly break-up of the eurozone and fixing the financial system should be urgent tasks now.
We cannot continue having the bankers threaten to blow up the world unless everybody does what the bankers demand.
How could default by a small country bring Europe to its knees, and how could the ‘Balkan powder-keg’ explode with the loss of an unprecedented eight million lives in the First World War? Big problems start small. It’s the history of our species.
Yes, the global financial system remains in disrepair after its faultlines were so dramatically revealed in 2008-09. And the eurozone needs greater political and fiscal unity. Indeed, the latter is a centrepiece of the latest ‘comprehensive strategy’ for eurozone reinvention.
But first things first. As a practical matter, Germany still relies on its eurozone peers for 40 per cent of its export revenues. Confidence, that precious commodity, must be restored among global investors – individual, corporate and institutional. The place to start is Greece, ground zero of the panic. But Europeans from Sheffield to Poland’s eastern frontier must be relieved of the uncertainty of a wider economic implosion for want of the liquidity injection required now to ensure the functioning of all sovereigns.
Some big problems may start small but small problems rarely lead to big ones. When they do, they are often just a symptom, not a cause. From Greece to Ireland, from the Bank of America to French banks or to some obscure special investment vehicle in the Caymans, there are problems everywhere. They are all symptoms of a sick financial system and a problematic eurozone.
Even if Greece were to disappear tomorrow, the world’s confidence is unlikely to recover as long as the two big problems are left festering. I have yet to see a realistic proposal for Greece that does not involve some form of default. The 26 October agreement included a 50 per cent haircut to bondholders – an example of ‘orderly’ default.
If not an orderly default then a disorderly one becomes highly likely. Only an outright grant to Greece could prevent the need for a default but I don’t see how it could occur.
All parties would better prepare for a default then. Unforeseen events will take place but it will also likely force longer-term solutions for finance and the eurozone.
If sovereign bondholders aren’t a tad sanguine about taking a sizeable ‘haircut’ in a renegotiation of Greek debt, they should be. Indeed, investors are getting a hard lesson on the new euro-economics, in which for political reasons they will have to share in the sacrifice required to keep the eurozone fiscally whole. That the lesson has been absorbed is clear from the sudden (relatively speaking) ill repute of Italian and Spanish debt, and the shocking run on French obligations. This is not a Greek crisis, but a systemic one. And indeed, the opportunity cannot be missed to use the upheaval as a catalyst for sweeping fiscal reforms across the eurozone. Those will be made more palatable by an Italian taking charge of an ECB widely regarded as the former German central bank with a new name.
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