The consequences of political stupidity
“Papandreou’s move also exposes the fatal flaw of grand plans for a political or fiscal union to support the euro: the “people,” not governments, remain the real sovereign. Governments may sign treaties and make solemn commitments to subordinate their fiscal policy to the wishes of the EU as a whole (or to be more precise, to the wishes of Germany and the European Central Bank); but, in the end, the people may reject any adjustment program that “Brussels” (meaning Berlin and Frankfurt) might want to impose.” (An except from “The Revolt of the Debtors” by Daniel Gros, Director of the Center for European Policy Studies, in an op-ed on Project Syndicate, November 3, 2011)
We are about to witness a major credit crisis unfold yet again. This time, the culprit isn’t inflated housing values or sub-prime mortgages. No, this crisis is a lot more political than it is financial.
At the center of the crisis we find Greece, a small peripheral nation that has long lived beyond its means. As Greece is a member of the European Monetary Union (otherwise known as the Eurozone), a community of nations who share the same currency, it finds itself in a rather remarkable predicament of having to rely on other Eurozone members to bail it out so that it won’t default on its obligations to bond holders — many of which are Europe’s biggest banks.
The governments of Germany and France, who are major contributors to a stability fund — the EFSF — that provides the bailout payment stream to Greece and other peripheral nations, are demanding that in exchange for a bailout, the Greek government must institute a series of deep austerity cuts that have so far proven to be quite useless in solving Greece’s economic woes. Until now, the austerity measures demanded by France and Germany have been passed by the Greek parliament despite huge public opposition. It appears, however, that you can’t keep the electorate quiet for long.
Following last week’s summit where European leaders have agreed tentatively to expand the existing 400 billion Euros European Financial Stability Facility by an additional 1 trillion Euros, Greek prime minister George Papandreou surprised officials this past Monday by announcing he would hold a public referendum on the additional austerity cuts demanded by France and Germany in exchange for an 8 billion Euros payment so that Greece could pay its bondholders in December. According to Papandreou, the referendum is necessary so that the Greek electorate can decide if they would like to remain in the Eurozone. European leaders were blindsided by the decision. In an emergency summit that took place yesterday in Cannes, the leaders of France and Germany gave Greece an ultimatum: pass the austerity cuts that we demand without a referendum or go bankrupt.
“The EU remains a collection of sovereign states, and it therefore cannot send an army or a police force to enforce its pacts or collect debt. Any country can leave the EU – and, of course, the eurozone – when the burden of its obligations becomes too onerous.”
European officials are being quite cavalier with their attitude towards Greece. While no one is denying that Greece has serious financial issues that must be addressed, the quick solutions that European leaders are seeking to alleviate the markets are non-existent. The austerity cuts that have been demanded by France and Germany are not necessarily designed to help Greece but rather please the electorate back home. Both the French and German public believe, and understandably so, that they should not foot the bill to bail out a small country that has been reckless with its finances for years. Germany’s Chancellor Angela Merkel and France’s President Sarkozy understand very well that if they don’t take a tough line with Greece, they would pay a heavy political price when they run for elections.
“As long as member states remain fully sovereign, investors cannot be assured that if the eurozone breaks up, some states will not simply refuse to pay – or will not refuse to pay for the others.“
The ramifications of a Greek default would be felt across the Eurozone. Whether European officials admit it or not, Greece is the one in the driver’s seat. Greece could very well refuse the bailout, default on its obligations to bond holders, and bring back the Dragma. If anything, many economists have argued that defaulting on its debt would actually be helpful to Greece in getting back on track. However, the consequences of a Greek default for the Eurozone as a whole would be enormously challenging. The exposure that French and Italian banks have to Greek bonds means that these banks would have to be recapitalized quickly to offset the losses.
Another by-product of a Greek default is that bond yields of troubled European economies such as Spain and Italy would surge, making it almost impossible for these nations to borrow money through the bond markets. The cracks are already starting to appear; the yield on 10-year Italian bonds reached a Euro-era high of 6.40% earlier today. Once the yield approaches 7%, it is generally recognized that borrowing costs at such high levels are unsustainable.
In the worst case scenario, the EFSF would now be tasked with bailing out Spain and possibly Italy. Greece found itself in exactly the same predicament early in the crisis, as did Portugal and Ireland. And what’s even more troubling is that while the European Central Bank has been buying Italian bonds in an effort to lower the yield, the yield has actually continued to rise as investors lose confidence in the ability of European officials to resolve the crisis. Today’s .25% rate cut by the ECB effectively signals that Europe is about to enter into major crisis mode.
The approach taken by European officials is quite baffling. Three years ago at the peak of the sub-prime crisis, U.S. Treasury Secretary Hank Paulson effectively gave a blank cheque to the banks and successfully prevented a collapse of the banking system. While we can argue about the merits of giving the banks so much capital, in the end it stabilized the financial system. While the monetary system of the Eurozone is very different from the U.S., what we need are bold thinkers at a time where the world’s banking system is once again at risk. The questions were asked later because U.S. officials understood that if they didn’t act quickly, a collapse of the banking system would lead to the collapse of not only the U.S. economy but the world’s economy as the credit markets dry up and consumers empty out their bank accounts.
One has to wonder why European officials aren’t thinking along the same lines given the calamity that’s ahead of them. Instead of providing Greece with the money it needs and signaling to the markets that Europe has the financial resources and political willpower to take care of its own problems, leaders have opted to engage in a game of chicken. This is a strategy that’s going to fail and drag everyone else along for the ride.
