Is Something Better than Nothing?

Greek Deal Leaves Europe on the Road to Disaster

By Clive Crook

If Europe’s new plan for Greece succeeds, nobody will be more surprised than the politicians who designed it. At best, the arrangement is a holding action, one that fails yet again to deal with the much larger confidence crisis facing the euro area.

The deal announced on Tuesday starts with private lenders. Their representatives agreed to accept even bigger losses on Greek government bonds than previously discussed. The bonds’ face value will be cut by 53.5 percent, and they’ll pay a low interest rate, starting at 2 percent then rising later. Altogether, this reduces their net present value by about 75 percent, far more than deemed necessary just weeks ago.

If enough private lenders go along, that triggers the inter-governmental side of the plan: new official loans to cover Greece’s ongoing budget deficit and replace debt coming due. The terms include a lower interest rate on bailout loans as well as various other kinds of European Union taxpayer subsidy, folded in with greater or lesser degrees of stealth. The European Central Bank and national central banks, for example, will pitch in by channeling back to Greece the “profits” they have made on Greek bonds bought at deep discounts to face value. The International Monetary Fund is going to take part, too. Exactly how still isn’t clear.

Drawing Board

If too many private lenders opt out, it’s back to the drawing board. Ditto if voters in Greece force the government to renege on promises to cut the minimum wage, make advance debt- service payments into an externally monitored account, change the constitution to prioritize debt repayment, accept oversight of public accounts by an on-site team of EU officials, and more.

That’s only a partial list of what might still derail the agreement. Even if it sticks, its designers don’t sound confident it will work. An official analysis leaked to the Financial Times discusses a “tailored downside scenario,” which, to many observers, looks more like a plausible central case.

In this projection, Greece postpones the structural changes -- such as a lowering of wages -- needed to make its economy competitive. Fiscal adjustment and privatization are delayed. The government’s dependence on official loans grows, and its debt burden surges higher. The debt trajectory would be “extremely sensitive to program delays,” the officials conclude, “suggesting that the program could be accident prone, and calling into question sustainability.”

Sounds like business as usual. All through this crisis, the EU has chosen to keep muddling through, never doing quite enough to resolve the problem, infusing each round of subsequent crisis-management with high political drama. Advocates of this method argue, with a particle of justification, that it’s working. Unilateral default has been avoided and pressure has been brought to bear on Greece and others to push ahead with economic reforms that were long overdue.

If there is some intelligent principle behind this approach, rather than mere flailing incompetence, it would sound like this: “Let’s build this manageable problem up into a crisis capable of vast destruction that we might be unable to control. That will create the fear needed to force some real improvements in economic policy.”

Panic is what first turned an EU liquidity crisis (where governments struggle to borrow money) into an insolvency crisis (where the burden of debt settles on an unavoidably explosive path). This financial metastasis works through interest rates. If rates stay high enough for long enough, they can make solvent governments insolvent. When panic gripped the markets recently and bond yields surged, the solvency of Spain and Italy -- plainly capable of servicing their debts under conditions of no panic -- was called into question. It beggars belief that the EU is willing to let the fear of a calamity on such a scale persist, when there’s no need.

Maximizing Panic

But it has been willing, and still is. The EU’s own financial officials doubt the new program will work. Greece may end up defaulting unilaterally -- the panic-maximizing event. Lately finance ministers have actually entertained the idea of a Greek exit from the euro as a way of bringing further pressure to bear on the government. Are plans in place for that contingency? Take a guess. If it happens, and bond yields spike again, there’s no firewall to protect the rest of the system. Europe’s banks are still undercapitalized and the European Financial Stability Facility is at best a third as big as it might need to be.

Greece is small enough for the rot to be stopped right there. Add in Europe’s other two acutely distressed economies -- Ireland and Portugal -- and the problem is still manageable.

Greece’s debts, official and privately held, should be written off. Until its government can get to a primary budget surplus or renew its access to market borrowing -- for which it needs some economic growth -- Europe should provide official financing on terms that won’t kill the economy. Euro exit must be avoided: Wages will have to fall, but dumping the common currency for a devalued drachma opens too many new channels of risk. The EU should stand ready, if need be, to do all this for Ireland and Portugal, as well.

In any event banks have to be recapitalized and the EFSF greatly enlarged. If all this were done, the risk of renewed panic would subside, and Spain, Italy and the EU as a whole would be moved back from the brink of disaster. The cost to euro-area taxpayers is not small, but it’s nothing compared with the crash they will suffer if this game of chicken with financial markets goes wrong.

What part of this doesn’t Europe understand?