European governments, with the help of the International Monetary Fund, have finally produced a package big enough to avoid a default by Greece, at least for the next two to three years. This does not mean that the future of the euro has been permanently secured, but it does suggest that the immediate financial crisis is probably over.
In the longer term, investors will continue to worry about the ability of the Greek Government to service its debts, but their worries will no longer have any effect on real economic conditions, because the Government’s financial needs for the next two to three years have been assured.
The only thing that could now cause a Greek default would be a failure by the Government to deliver on its promises so blatant that the EU and IMF would stop disbursing the promised €110 billion bailout. But while armchair analysts always love to speculate about a breakdown of public order and descent into anarchy, the experience of IMF austerity programmes in countries from Thailand, Indonesia and Mexico to Latvia, Romania and Hungary is that ordinary people are surprisingly willing to accept sacrifices when the government runs out of money.
Mr Dombrovskis knows what he is talking about. His country has just performed the largest fiscal consolidation ever recorded. About 30 per cent of public sector jobs have gone; the wages of the government workers who remained have been cut by 25 per cent; and a government deficit of 20 per cent of GDP has been transformed into a surplus of 8 per cent in only two years. That is roughly five times the pace of the consolidation demanded of Greece.
But while Greece has now escaped its immediate liquidity crisis, the country’s bonds will continue to be viewed as a junk credits and the prospect of sovereign defaults within the eurozone is no longer unthinkable.
Consider three implications from this sequence of events. The first will be that other weak governments in the eurozone will be perceived as serious credit risks. Portugal, even though it is far less indebted than Greece, will sooner or later suffer some Greek-style funding problems — and these, in turn, will raise questions about the bonds of the Spanish Government.
At that point, a second implication of this week’s bailout will come into play: other Club Med countries will not be bailed out in the same way as Greece. After all the controversy in Germany over the Greek rescue, the German political system simply could not come up with another bilateral loan for Portugal, never mind five or ten times as much money for Spain.
In this sense, Greece could be the Bear Stearns of the euro crisis, with Portugal playing the part of Lehman Brothers. The question then will be how to save Spain. That country is clearly too big to fail, in the same way that AIG and Citibank were, and would have to be bailed out, regardless of cost. But this brings us to the third implication of the Greek package.
Greece was easy for Europe to bail out, despite the reluctance of German voters, because it was a small country. But Spain is too big to save, at least with direct loans from other European governments. Europe’s only serious hope of bolstering Spanish debt would have been to devise a collective solution, whereby the EU as a whole would offer members emergency fiscal support.
This is what it did for Latvia, Hungary and Romania last year, when it authorised the sale of €50 billion of EU bonds, guaranteed by all EU governments. This was the solution I had expected in the case of Greece.
But by opting for bilateral support from individual governments in the case of Greece, EU leaders missed the chance to create a collective mechanism for eurozone fiscal bailouts — and this opportunity is now gone for ever, for a reason that almost nobody has yet noticed. With a Conservative-led government almost certain to take over, there will be no prospect of Britain agreeing to a new bond issue by the EU as a whole of the kind that might have been possible a month ago. Since the euro group on its own does not have the “legal personality” required to issue bonds, a collective rescue for the next troubled country is now out of the question.
What, then, will happen if investors in another Club Med bond market decide to go on strike? While Europe has no political or fiscal institution strong enough to arrange another rescue after the bailout of Greece, it does have a monetary institution with unlimited firepower.
If Portugal or Spain get into trouble, the European Central Bank could step forward as a buyer of last resort for all Club Med bonds. By following the Federal Reserve Board and the Bank of England and announcing a quantitative easing programme worth about 10 per cent of the eurozone’s GDP, the ECB could easily finance all the Club Med countries’ budget deficits for the next year or two. This is exactly what the Bank of England has done in monetising the whole of the British Government’s borrowing requirement over the past 12 months.
Central bank lending directly to governments is legally prohibited by the “no-bailout” clause in the Maastricht Treaty, but the ECB could easily get round this by lending to Spanish and Portuguese banks, which in turn would lend to their national governments. More precisely, the Spanish banks would buy their Government’s bonds without limit if the ECB guaranteed to accept these as collateral without regard to credit risk.
These were essentially the terms offered yesterday by the ECB to any euro-area banks wishing to swap their Greek government bonds into cash. In future, Greek bonds will be exchangeable at par at the ECB, regardless of any credit downgrades the government might suffer.
Significantly, the ECB has justified this unprecedented relaxation of its credit standards by citing the “strong commitment of the Greek Government to fully implement the [fiscal] programme. The Governing Council has assessed the programme and considers it to be appropriate.” Having made this decision for Greece, it will be only a small step for the ECB to extend the same concession to Portugal and then to Spain, provided that their governments agree to “appropriate” programmes.
For the ECB, unlimited lending to the Portuguese and Spanish governments, disguised behind the fig leaf of loans to their national banking systems, would be considered the nuclear option. European central bankers would be extremely reluctant to use it. But if the alternative was disintegration of the euro, the ECB would surely deploy this ultimate weapon, rather than simply capitulate to the markets.
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Fingers on the button at the ECB
European governments, with the help of the International Monetary Fund, have finally produced a package big enough to avoid a default by Greece, at least for the next two to three years. This does not mean that the future of the euro has been permanently secured, but it does suggest that the immediate financial crisis is probably over.
In the longer term, investors will continue to worry about the ability of the Greek Government to service its debts, but their worries will no longer have any effect on real economic conditions, because the Government’s financial needs for the next two to three years have been assured.
The only thing that could now cause a Greek default would be a failure by the Government to deliver on its promises so blatant that the EU and IMF would stop disbursing the promised €110 billion bailout. But while armchair analysts always love to speculate about a breakdown of public order and descent into anarchy, the experience of IMF austerity programmes in countries from Thailand, Indonesia and Mexico to Latvia, Romania and Hungary is that ordinary people are surprisingly willing to accept sacrifices when the government runs out of money.
Mr Dombrovskis knows what he is talking about. His country has just performed the largest fiscal consolidation ever recorded. About 30 per cent of public sector jobs have gone; the wages of the government workers who remained have been cut by 25 per cent; and a government deficit of 20 per cent of GDP has been transformed into a surplus of 8 per cent in only two years. That is roughly five times the pace of the consolidation demanded of Greece.
But while Greece has now escaped its immediate liquidity crisis, the country’s bonds will continue to be viewed as a junk credits and the prospect of sovereign defaults within the eurozone is no longer unthinkable.
Consider three implications from this sequence of events. The first will be that other weak governments in the eurozone will be perceived as serious credit risks. Portugal, even though it is far less indebted than Greece, will sooner or later suffer some Greek-style funding problems — and these, in turn, will raise questions about the bonds of the Spanish Government.
At that point, a second implication of this week’s bailout will come into play: other Club Med countries will not be bailed out in the same way as Greece. After all the controversy in Germany over the Greek rescue, the German political system simply could not come up with another bilateral loan for Portugal, never mind five or ten times as much money for Spain.
In this sense, Greece could be the Bear Stearns of the euro crisis, with Portugal playing the part of Lehman Brothers. The question then will be how to save Spain. That country is clearly too big to fail, in the same way that AIG and Citibank were, and would have to be bailed out, regardless of cost. But this brings us to the third implication of the Greek package.
Greece was easy for Europe to bail out, despite the reluctance of German voters, because it was a small country. But Spain is too big to save, at least with direct loans from other European governments. Europe’s only serious hope of bolstering Spanish debt would have been to devise a collective solution, whereby the EU as a whole would offer members emergency fiscal support.
This is what it did for Latvia, Hungary and Romania last year, when it authorised the sale of €50 billion of EU bonds, guaranteed by all EU governments. This was the solution I had expected in the case of Greece.
But by opting for bilateral support from individual governments in the case of Greece, EU leaders missed the chance to create a collective mechanism for eurozone fiscal bailouts — and this opportunity is now gone for ever, for a reason that almost nobody has yet noticed. With a Conservative-led government almost certain to take over, there will be no prospect of Britain agreeing to a new bond issue by the EU as a whole of the kind that might have been possible a month ago. Since the euro group on its own does not have the “legal personality” required to issue bonds, a collective rescue for the next troubled country is now out of the question.
What, then, will happen if investors in another Club Med bond market decide to go on strike? While Europe has no political or fiscal institution strong enough to arrange another rescue after the bailout of Greece, it does have a monetary institution with unlimited firepower.
If Portugal or Spain get into trouble, the European Central Bank could step forward as a buyer of last resort for all Club Med bonds. By following the Federal Reserve Board and the Bank of England and announcing a quantitative easing programme worth about 10 per cent of the eurozone’s GDP, the ECB could easily finance all the Club Med countries’ budget deficits for the next year or two. This is exactly what the Bank of England has done in monetising the whole of the British Government’s borrowing requirement over the past 12 months.
Central bank lending directly to governments is legally prohibited by the “no-bailout” clause in the Maastricht Treaty, but the ECB could easily get round this by lending to Spanish and Portuguese banks, which in turn would lend to their national governments. More precisely, the Spanish banks would buy their Government’s bonds without limit if the ECB guaranteed to accept these as collateral without regard to credit risk.
These were essentially the terms offered yesterday by the ECB to any euro-area banks wishing to swap their Greek government bonds into cash. In future, Greek bonds will be exchangeable at par at the ECB, regardless of any credit downgrades the government might suffer.
Significantly, the ECB has justified this unprecedented relaxation of its credit standards by citing the “strong commitment of the Greek Government to fully implement the [fiscal] programme. The Governing Council has assessed the programme and considers it to be appropriate.” Having made this decision for Greece, it will be only a small step for the ECB to extend the same concession to Portugal and then to Spain, provided that their governments agree to “appropriate” programmes.
For the ECB, unlimited lending to the Portuguese and Spanish governments, disguised behind the fig leaf of loans to their national banking systems, would be considered the nuclear option. European central bankers would be extremely reluctant to use it. But if the alternative was disintegration of the euro, the ECB would surely deploy this ultimate weapon, rather than simply capitulate to the markets.
