Europe's fragile bonds

Greece is heading for default. If France and Germany decline to help, the eurozone—and Europe—could face disaster
June 22, 2011
Riot police guard the National Bank of Greece, Athens. Violent protests against the government’s austerity measures have paralysed the city

The eurozone is based on three pillars: loopholes, fudges and lies. They made this crisis inevitable. The propensity to fudge now makes any real resolution all but impossible, even if it contains the problem.

The fudges and loopholes stretch back to the deals that created the euro in the early 1990s. The Maastricht Treaty, in force from 1st November 1993, committed signatories to the new currency, which came into existence on January 1999. The eurozone’s advocates made promises that were inconsistent, but irresistible. The Germans were promised that monetary union would not oblige them to pay their tax revenues to other countries, and that it would create a currency at least as strong as the Deutschmark. The French perceived the euro to be a tool to strengthen Europe’s global reach. For the Italians and the Spanish, the new currency offered permanently low interest rates. Given their deregulated banking systems it also brought sudden wealth by way of a housing bubble.

These inconsistent promises were reflected in the governance of the currency bloc. There was no attempt to co-ordinate countries’ tax and spending policies other than through broad budget rules (soon broken). The most important was the famous 3 per cent ceiling: the maximum budget deficit that a country would be allowed compared to its gross domestic product (GDP). The philosophy was that monetary and fiscal discipline should be sufficient for the euro’s long-term sustainability. The independent European Central Bank (ECB) would adjust interest rates to contain inflation. The “stability and growth pact,” which aimed to co-ordinate national policies within the euro area would enforce fiscal discipline. And that was it.

The lies, loopholes and fudges gave rise to another trinity: no exit, no default, and no bailout—a logically inconsistent set. The pledge not to bail out troubled economies was enshrined in European law. The no exit principle is an indirect consequence of Maastricht: there is simply no procedure for a country giving up the euro once it has joined. In theory, the country could leave the euro only by the “nuclear option” of withdrawal from the EU. The principle that a eurozone country will not default—fail to make payments on its debt—is not in the treaty. But it followed once the ECB accepted each country’s collateral on the same terms—that is, treated their debt as equally risky, even though the economies were so different.

Then came the global financial crisis of 2008.

Even if it is seen a fiscal crisis today—a problem of countries spending too much and running up debt—it was not one in origin. The cause was a collision of macroeconomic imbalances with a badly regulated and undercapitalised banking system. German banks helped to channel German savings surpluses into Spain and Ireland, creating housing bubbles in the process. In 2008 these imbalances were at their height.

But it was not yet a fiscal crisis. Spain and Ireland ran surpluses for most of the last decade, with the result that both were considered righteous. Portugal ran deficits, but its debt-to-GDP ratio was only a little higher than that of France and Germany. Greece was the only one that produced a classic fiscal crisis. Eurostat, the EU’s statistics office, revealed that in 2009, Greece ran a budget deficit of 15.4 per cent of GDP. Athens had lied about its deficit figures when it applied to join the euro.

The error that turned a crisis of financial imbalances into a fiscal crisis was the eurozone’s response to the September 2008 collapse of Lehman Brothers. In October, eurozone leaders decided that each country would guarantee the solvency of its own banking sector. If they had instead set up a eurozone-wide rescue fund, and a scheme for winding up stricken banks, there would never have been a fiscal crisis anywhere but Greece.

Leaders then committed the error of focusing on symptoms not causes. Nobody wanted to let go of the self-deception that if all eurozone nations ran their budgets within proper limits, that would be enough to keep the currency bloc stable. You still hear elderly German professors and central bankers talk about this crisis in terms of fiscal profligacy alone—the “spendthrift south.” But if you believe that profligacy is the cause, then austerity must be the answer. That is why each attempt to resolve this crisis has brought a prescription for austerity—cutting costs and raising revenue—no matter whether the country’s fiscal policy was at the root of the crisis or not.

How is this crisis likely to be resolved? When they agreed the first loans to Greece in May 2010, officials from the EU and the International Monetary Fund (IMF) believed it had a good chance of pulling through, by spending cuts, raising more tax from those who had avoided it for decades, and wider reforms. A year later, the consensus is that Greek public sector debt is not sustainable: Athens will probably have to default on its payments.

This is where it gets extremely messy. Angela Merkel famously pledged that all eurozone bonds would be safe from default until 2013. The German chancellor agreed this with Nicolas Sarkozy, France’s president, during their famous walk on Deauville’s beaches in October 2010. The idea was to “roll over” the debts of highly indebted eurozone countries until 2013, when they would be judged solvent, or not. If insolvent, then private investors would take a hit.

But political shifts in the richer countries have thrown that strategy off course. Put bluntly, their politicians don’t see why they should use their taxpayers’ revenues to bail out other countries. The success of the True Finns, a nationalist party in Finland, means that support for bailouts is in doubt there. In Germany, politicians have even questioned whether it is still in the national interest to belong to the euro. The German government wants private investors who have bought euro denominated bonds to share the bailout costs. The ECB is horrified, believing that this would trigger mass sales of debt, and economic collapse.

In one option under discussion, bondholders would exchange bonds with short-term maturities for ones with long maturities. That would give debtor countries a respite from repayment. It is portrayed as more or less voluntary, but “voluntary restructuring” is, of course, an oxymoron. In reality, the idea is to get a group of large investors into a room, and bang heads together. Genuinely voluntary schemes are rarely sufficient. Yet a forced exchange, in which debt holders are pressed into accepting new terms, would almost certainly lead to a sharp downgrading of debt by rating agencies. Such a debt exchange was tried before, in Argentina. Its failure accelerated the messy default in 2001.

Voluntary rescheduling can work in countries that are solvent but face a temporary liquidity squeeze. That is not the case in Greece, where the debt-to-GDP ratio is projected to reach 160 per cent in 2012. The situation is so serious that half-measures may be the worst of all options. If you default, do it properly. A default with a 50 per cent or more “haircut”—where holders of the bonds accept a loss—is probably what it would take to enable Greece to meet payments. It would still have to carry out big reforms. After all, the aim for Greece is to stay in the eurozone, so the old resort of devaluing the currency is not an option.

The only benefit of a voluntary scheme is that it might give political help to northern eurozone countries. Without that, the parliaments might never agree to more loans for Greece.


What happens next? It is likely that, after much noise, eurozone governments will put together a second package of loans to Greece, in the summer or autumn. The assumptions made at the time of the first Greek bailout, in May 2010, were too optimistic. Greece has not been able to shrink its deficit that fast, despite ferocious spending cuts, which have also impeded growth. The new package would aim to shore up Greece’s finances until 2014.

But it would probably fail. I would expect that this second package would also soon seem too little—probably by next year. It assumes unrealistically high receipts from the sale of national assets, but who is going to buy Greek assets now? I would also expect that Ireland and Portugal will come back for more money.

If the second package proves as inadequate as the first, there will be great pressure from German and Finnish eurosceptics to let Greece default. But I would assume that when faced with the straight choice of a Greek default or making another small loan, political leaders in Germany and elsewhere will choose to make another loan. Default would cut Greece off from capital markets for several years. This would risk contagion—a plunge in other eurozone debt, and in the shares of banks which hold it. This factor alarms governments far from Athens—Beijing and Washington included—because it could affect world markets.

The ECB itself has a total exposure to Greece of between €150bn and €200bn. This includes Greek assets deposited as collateral, as well as the sovereign bonds the ECB had bought to stabilise bond markets. If Greece defaulted, and its banking system were to collapse, most of the ECB’s exposure would be at risk. It could, in theory, print more euros to make good its losses. But that would clearly be against the rules.

Instead, the ECB would most likely accept the losses. That would force national central banks immediately to recapitalise it. Member states would also have to contribute to the shortfall. If Greece were also to default on the €110bn loan from the EU and the IMF, eurozone states would also have to reimburse those bodies. They might also have to recapitalise their own banks to make good their losses from a Greek default.

My hunch is that leaders will be as reluctant to accept a Greek default in 2013 as they are today. They will give Greece, Ireland and Portugal yet another bridging loan. By 2015, a large chunk of the sovereign debt of the countries on the periphery of the EU will be held, or guaranteed, by the EU creditor nations. The “collective action” clauses which allow a majority of bondholders to agree on a restructuring will be irrelevant. So will “investor bail-ins,” where losses are imposed on bondholders to pay for bailouts of a national government. There will be no private sector left to bail in; it will have bailed out by then.

The repayment dates on bonds may be extended to 50 years, and the interest rate may be cut towards zero. In extremis, it is not unimaginable that a perpetual zero-coupon bond will come into being—it would pay no interest and never be repaid.

In this scenario, the European council would expand the EU’s crisis scheme into a proper debt agency, which would gradually absorb all troubled country debt. Even Spain might eventually come under this umbrella. By my calculations, Spanish house prices have a further 20 to 30 per cent to fall, as do real incomes. It will happen slowly, and it may take over a decade, but it will wipe out large chunks of that country’s savings bank sector.

If Spain were to require credit from the EU, alarm would immediately extend to Italy which has public debt equal to 120 per cent of GDP, the third highest in the world. If the markets turned on Italy, it would no longer be willing, or able, to honour its bailout commitments to others. If Italy then defaulted, I cannot see Germany and France being willing to bankroll the entire system. At that point, the intra-governmental approach would have broken down. The eurozone would face a direct, extreme choice: a jump into a closer political union, or breakup.

A closer political union would demand that they consider common eurozone bonds, co-ordinated economic policies and a centralisation of banking guidelines. My guess is that they would choose this option; but this is far from assured.

Would political union be a good outcome? Think of it this way: the eurozone would survive in one piece. There would be no blood on the streets, just a once-and-for-all bailout. Fiscal union would still be very limited. This bailout would be relatively cheap, too. I estimate that a maximum of €500bn would be needed in bank recapitalisation. This is still less than 10 per cent of eurozone GDP, a manageable burden, since the eurozone has a lower debt-to-GDP ratio than both Britain and the US.

It might not be manageable, however, if each country were left alone to sort out its own problems. We can resolve this crisis properly either through a series of national defaults, which will be damaging, or by closer political union of the eurozone. No resolution will come through the current fudge of intra-governmental insurance, whereby governments in the north drip feed money to the broken fringe of Europe.

This fudge raises the chance of a game-changing accident. Merkel may be serious about the Deauville commitment to roll all debt over until 2013, but a revolt in her parliament or elsewhere could force a premature default. Political panic could break out in Athens. There could be a realisation that the Spanish savings banks are in much worse shape than recognised, or French sovereign bonds could be downgraded. The list of potential accidents is long, any of which might trigger a crisis in the eurozone bigger than that following the Lehman collapse.

My best guess is that they will fudge until they reach the point of unfudgeability. That is likely to be a political crisis, testing the limits of the richer countries’ willingness to pay for the periphery-—and their commitment to the principles which have inspired the EU. Eventually they will face a choice—but I would bet that this choice will be left to another generation of political leaders. Their decisions will determine whether Europe, in its current form, can go on.