Whatever happens to Greece, the failings of the euro zone have not
been addressed

Greece beyond the edge

The Economist, February 18th, 2012

Bill Hicks, a comedian, used to joke that there must be a “ledge beyond the edge”. How else could the survival of Keith Richards be explained? What goes for rock stars also appears to go for Greece, which has been on the brink of a second bail-out package for weeks.

Deadlines have already been missed. A meeting of the Eurogroup of finance ministers, scheduled for February 15th, at which the terms of a deal were supposed to have been endorsed, was postponed the day before. Euro-zone ministers wanted more details of proposed spending cuts as well as written assurances that Greek politicians won’t renege on the deal once a general election, pencilled in for April 8th, is over. Greece has consistently missed its targets to date; trust among its troika of rescuers—euro-zone governments, the IMF and the European Central Bank (ECB)—that it will stick to a new agreement is low.

The delays may reflect the brinkmanship that is part of any tough negotiation. Greece is short of cash but not of bargaining chips. Without fresh bail-out money, it faces a chaotic default on its public debt. That might provoke wider contagion. Its rescuers, for their part, are putting pressure on Greece to commit to further austerity and reform by sounding sure that fallout from a messy default could be contained.

The way financial markets shrugged off news of the cancelled summit suggests that investors are confident that a deal can still be reached when the Eurogroup next meets on February 20th. There is a deadline that ought to concentrate minds: Greece has a €14.4 billion ($18.8 billion) bond that falls due on March 20th.

A scheme under which private investors would “voluntarily” take losses, by swapping their Greek bonds for longer-dated ones with half the face value, has to be completed before then. Around €30 billion of the second bail-out pot is set aside for guaranteed euro-zone bonds to sweeten the swap deal. The process may have to start before that money is in place, which will make some bondholders reluctant to take part. The deal could easily unravel.

The pressures on Greece are even more acute. Its economy shrank by 7% in the year to the fourth quarter of 2011. The fall in GDP in the final three months of 2011 was around 5%, according to Haver Analytics, compared with an average fall of 0.3% across the whole euro area. That made the Greek economy the worst of a sorry bunch (see chart). Uncertainty is the economy’s biggest problem. Businesses will not invest until Greece’s future in the euro is secure; nor will suppliers extend Greek firms credit, worsening a savage liquidity shortage.

Greece has missed its fiscal targets, in part because of the deepening recession. The budget deficit in 2011 was probably close to 10% of GDP, barely changed from 2010. But European leaders agreed on €130 billion for Greece in October and are loth to ask their parliaments to approve a bigger sum now. The ECB will have to forgo the profits on the Greek bonds it bought at a discount if Greece is to have a chance of cutting its debt burden to 120% of GDP by 2020. More immediately, Greece has been asked to make €3.3 billion of extra cuts this year. That will prolong the recession. Private-sector wage cuts needed to restore Greece’s competitiveness will make things worse in the short term.

The growing social tensions in Greece mean its politicians cannot embrace yet more cuts with much enthusiasm. But Greece’s official creditors have their own reasons to get cold feet about another rescue package. Most of the new bail-out money will be disbursed this year to cover Greece’s big budget deficit; to enhance the bond-swap deal; and to inject capital into Greek banks after they have taken losses when privately held Greek bonds are restructured. Once this rescue money is paid, euro-zone governments will have fewer means of taking Greece to task.

What’s more, from 2013 Greece is supposed to sustain a series of “primary” budget surpluses (ie, excluding interest payments) so as to cut its debt burden. But once the state has eliminated its primary deficit, it will not need external finance to fund its day-to-day operations. If Greece then refuses to run big surpluses, a second round of debt restructuring would beckon. That would hurt official creditors, as well as the remaining private bondholders.

One way to keep Greece in line would be to stagger the bulkier bail-out payments. The money required to get private bondholders to take losses cannot be delayed if Greece is to avoid default. The troika could, however, withhold the funds reserved to recapitalise Greek banks. That would give them leverage over the government that is formed after Greece’s elections, which would have to use promissory notes in lieu of capital. But it would also spur a fresh round of deposit flight from banks, worsening the liquidity shortage that has made the recession so harsh.

Greece’s euro-zone creditors might be willing to live with that outcome. They have been emboldened by the success of the ECB’s three-year bank loans in pushing down bond yields for troubled-but-solvent countries like Italy and Spain. Germany’s finance minister, Wolfgang Schäuble, said on February 13th that Europe is “better prepared” for a Greek default than it was two years ago. Perhaps, but without continuing external support in the event of default, Greece might also be forced to leave the euro.

There remain large gaps in the euro zone’s defences against contagion should that happen. The euro-zone rescue fund, capped at €500 billion, is designed to rescue only small countries. Its size is limited by its structure: the more countries that have to be bailed out, the fewer there are to take on the burden of rescuer. It could not credibly bail out Italy, for instance, were that necessary. A jointly issued Eurobond would allow burden-sharing across all countries but would also require governments to give up some control over their tax-and-spending decisions. The reaction in Greece to impositions by its creditors shows how hard that would be.

The failings of the euro as a currency zone have barely been addressed. The lack of a co-ordinated fiscal policy, and the loss of competitiveness (and banking troubles) at its periphery, help explain why it has tipped into recession, says Laurence Boone of Bank of America. The chosen remedies are fiscal austerity, structural reform and deleveraging by banks. Given enough time, these measures might restore the zone to health. But they might first push some countries off the ledge.