Eurozone bond markets have for years now been operating under the assumption of a new “impossible trinity” (1/): That you can’t have a single currency, a (virtually) independent fiscal policy and a no-bailout clause all at the same time.
This assumption has continued to prevail even after the recent budgetary shenanigans in Greece (and fiscal slippages also elsewhere in the eurozone), judging from the latest pricing of Greek sovereign CDS.
While much wider than in early October, when the new government took office, Greek 5yr CDS spreads, at 200bps on Friday, still price in just a 6-8% probability of a credit event. (By comparison, Dubai Holding’s spread closed at 1870bps and Ukraine’s at 1350bps).
Markets are probably right… Most likely, Greece will deliver a series of fiscal consolidation promises to the Euro group (of eurozone finance ministers), will become subject to enhanced surveillance by the European Council under the Maastricht Treaty’s “excessive deficit procedure” (EDP) and, as such, obtain an implicit financial backstop from its eurozone fellows…
But here are the problems with this approach:
First, Greece (and some other vulnerable eurozone members) would be better off with an explicit financial backstop, not an implicit one. The EU’s backstop will always have to be implicit to avoid moral hazard and complacency by the Greeks, the Irish, etc. However, an explicit backstop would be much more effective in stabilizing the Greek bond markets and in curbing uncertainty about potential financing troubles.
Second, any EU backstop would likely come after a crisis hit, instead of being pre-emptive. That’s lousy policy, not least because, were a crisis to hit, it would raise uncertainty and possibly spread to other markets, even if the EU were quick to step in. It’s also lousy because there is absolutely no excuse for not having a crisis-prevention framework into place (over and above Greece’s own policy promises, for what they’re worth): Greece’s fiscal quagmire has been known for a long while, so policymakers would not exactly be caught by surprise!
Third, the European Commission/Council have a truly hopeless track record of enforcing fiscal consolidation or structural reforms on eurozone members. This means that whatever plan is laid out for Greece, it could lack the credibility to pass the “rating agencies’ test”, let alone the “markets’ test.” Ongoing uncertainty and lack of credibility would only breed volatility, which is neither good for Greece nor for investors still recovering from the Great Panic of 2008. In addition, to the extent that the Europeans prove, once again, incapable of enforcing fiscal and structural reforms, implementation slippages by Greece would set a dangerous precedent for other eurozone members to follow.
Fourth, direct involvement by eurozone governments in Greece’s fiscal plan (and, if need be, bailout) raises issues of conflicts of interest. It could turn out, a couple of years later, that Greece cannot put its finances in order.
This is not just a thought experiment by the way: Greece’s fiscal problems are deep-rooted and structural—a symptom of endemic problems, including an over-bloated and unproductive public sector, a pervasive culture of tax evasion, and widespread corruption at every imaginable level, from politics to the judiciary to the hospitals! This has hurt not only the government’s ability to put its finances in order; it has also hurt Greece’s competitiveness as a place to do business, undermining future growth (and, in turn, the fiscal dynamics).
If fiscal consolidation measures and structural reforms fail to deliver the necessary correction, the next route to follow may have to be debt restructuring. And here, the Europeans have too much at stake: Almost 70% of Greece’s near-EUR300 billion debt is held by foreigners, with a big chunk of it by French, German, Italian and other eurozone institutions (per the BIS). It is easy to see why the Europeans would not be “neutral” negotiators, and likely force too big a burden of adjustment on the Greek side.
This may sound “fair” on the surface, yet consider that these guys have completely failed to impose even a modicum of market discipline in recent years, being lured by the appeal of Greek debt as a euro-denominated product with an easy spread!
So here is a better and cleaner way to go: Greece should seek a “precautionary standby arrangement” (SBA) from the International Monetary Fund (IMF).
Under the SBA, Greece would commit to a combination of deficit-reducing and structural policy measures over 2-3 years (frontloading the former to sharpen the “teeth” and credibility of the SBA). The arrangement would be precautionary, with no IMF resources drawn in the baseline scenario where Greece faces no financing gap. However, Greece would have immediate access to Fund resources in an adverse scenario of financing troubles due to either a Greek-related or an “exogenous” market turmoil.
The advantages of this route compared to an EU solution are enormous in my view:
1. Greece would enjoy an explicit financial backstop rather than an implicit one.
2. The backstop would help prevent any crisis from happening, instead of cleaning up the mess ex post facto.
3. Provided the SBA has “teeth”, the seal of the IMF would be a great palliative for the markets, helping impart credibility to a government that has none.
4. By laying out specific benchmarks/conditionalities, compliance with these would be easy to monitor by the markets and by the Greek public, reinforcing government accountability.
5. The Maastricht Treaty’s “no-bailout” clause would remain intact, while the ECB would be able to maintain its autonomy over monetary policy and liquidity provision decisions, which would fortify the credibility of the euro.
6. The arm’s length (or, at least, indirect) involvement of Eurozone governments to the process would avoid the conflicts of interest I mentioned above.
7. Finally, Greece could set an example for other eurozone members to follow, helping maintain stability across the eurozone.
It is easy to see why some European policymakers might balk at this idea, out of concern it would amount to an acknowledgement of failure to deal with bread-and-butter problems in their own back yard. As a matter of fact, it is! The Stability and Growth Pact needs major rethinking (more on this in a subsequent piece).
But while Europe’s economic integration goes through yet another phase of soul searching, let the necessary measures of fiscal and economic stabilization proceed in a clean and orderly way.
1/ The original “impossible trinity” in international economics is the argument that you can’t have a fixed exchange rate, an autonomous monetary policy and free international capital flows all at the same time.
Originally published at Models & Agents and reproduced here with the author’s permission.