How should the Eurozone handle Greece?

By: Daniela Schwarzer and Sebastian Dullien

After weeks of contradictory statements on the question how to handle Greece, the Heads of State and Government of the EU member states used their informal European Council meeting on February 11^th  for a strong political signal that aimed at calming markets and giving political support to the Greek Prime Minister’s budgetary consolidation efforts and structural reform programme. The subsequent meeting of the EU’s Finance Ministers on February 16^th meanwhile increased pressure on the Greek government for further consolidation, taking the Excessive Deficit Procedure to its next step in which the Finance Ministers issue precise recommendations for Greece and increase surveillance in the country.

 

The European Council’s announcement that the EU “will take determined and co-ordinated action, if needed, to safeguard financial stability in the euro area as a whole” was widely interpreted as a bail-out promise. But only a few days after the summit, new doubts arose whether the EU or its larger member states would indeed step in for Greece. So, the options that are discussed still range from default and a Eurozone exit to a strong engagement of the EU and the creation of new crisis management and coordination mechanism for the Eurozone.  Despite increasing market instabilities and the rapidly approaching moment of truth when Greece will have to refinance its debt in March/April 2010, policy makers still assess options. This is not surprising, as there is no cheap and safe solution. Any political choice in this current situation has downsides. And no matter how the Greek case is handled, it will be a precedence for the future of EMU governance.

 

We assess four – arguably simplified – policy options and their pros and cons that have been put forward in the discussion.  We think that letting Greece default (option I) is neither a likely nor a reasonable scenario given the current set-up of the EU. We would not entirely exclude the possibility that the EU commits serious political mistakes in handling the problem so that Greece has to call in the IMF for help unilaterally (option III), but the most likely scenario from our perspective is that the EU member states will come up with a rescue package for Greece if needed (option II). The argument then is whether this should be done in a concerted action with the IMF or not. Given the current state of governance mechanisms in the EU, the risk of political tensions within the EU and problems of legitimacy of a bail-out, we rather expect an involvement of the IMF. But we suggest that this should be clearly limited in time while, in parallel, the Eurozone should be equipped with its own European Monetary Fund and a default procedure in order to limit moral-hazard problems in future cases.

 

Option I: The default option: Greece gets neither liquidity help, nor credit, nor gifts from the EU partners – and defaults in a disorderly way on its debt in the course of 2010

 

The pros

-          Any financial assistance from the EU partners would increase the moral-hazard inherent in the construction of the EMU. In particular, Spain (or Portugal or Ireland) could become a “second Greece” if a lack of reform efforts is “compensated” by a rescue package.

-          Letting Greece default on its debt could hence set an example for self discipline. Member states are to conduct structural reforms and pursue sound public finances to avoid another default.

-          Not supporting Greece would be true to the “no-bail-out-clause” of the Maastricht treaty.

-          It would satisfy public opinion in countries such as Germany where a majority does not want their tax money to be used for a bailout of the Greek in particular after they have used false budget data to get into the Eurozone and to prevent sanctions under the Stability and Growth Pact.

 

The cons

-          Letting Greece default may provoke self-fulfilling speculation against other vulnerable countries such as Portugal, Ireland and Spain, all of which are vulnerable with double digit budget deficits which need to be financed. In contrast to Greece, Spain is relatively large and a default would send a shock through financial markets, seriously hurt economic growth in Europe and would destabilize the EU politically.

-          The EU banking sector could be seriously destabilized. Most of Greece’s government debt is held abroad, more than €200bn by European banks. German banks hold about €30bn, French banks something like €55bn. Even worse problems would arise in the case of a Spanish bankruptcy.

-          A default would severely weaken the Greek government, possibly driving it out of office. It would become harder if not temporarily impossible to implement budgetary consolidation and structural reforms in Greece.

-          The problem of Greece’s lack of competitiveness would not be solved. The default would not be accompanied by a unilateral currency devaluation unless Greece decides to leave the EMU. While the Euro would probably devalue further, Greece’s weak competitiveness position within the Eurozone would not improve.

-          A disorderly default could create so much political turmoil in Greece that the country decides at some point to leave the euro, followed by a disorderly depreciation similar to that of Argentina in 2001.

-          A sovereign default inside the euro area would harm the EU’s image in the world.

 

Our assessment

We think that default the most unlikely scenario and we would definitely not recommend testing it. Greece will probably be bailed out because the risks of a banking crisis and a contagion to other highly indebted member states are taken seriously among policy makers.  Furthermore, should the EU partners decide not to help Greece (either with or without the IMF – see options IIa and IIb below), Athens itself could still call on the IMF (see option III) to get financial support (even though this does not necessarily prevent a default further down the path).

From a systematic point of view, we agree that the possibility to default is the best means to make governments as responsible as possible for their own action, in particular in a currency union. But the close economic and financial linkages between euro area countries make the default option an implausible threat since partners would hurt themselves as well.

The Eurozone lacks the governance mechanisms that would enable the EMU members to let a partner down without causing chaos: there is no orderly default mechanism and the costs of a disorderly default are simply too high. The Eurozone needs its own Euro-Monetary Fund (along the lines proposes by Thomas Mayer and Daniel Gros) and – as quick as possible – an orderly default procedure to reduce moral hazard in the Eurozone and make national governments more responsible for their own behavior.

 

Option IIa and IIb: There will be a rescue package by the EU or some member states. Option IIa discusses a rescue package without the IMF, option IIb a rescue package with the IMF.

For both options, we will not discuss the arguments for or against the scenario that the EU actually jumps in, because this – in precisely the opposite logic – would mirror the arguments for and against a sovereign default of Greece listed above. What we discuss here are the options that the EU gets active alone or with the help of the IMF.

 

Option IIa: The EU provides a rescue package alone. This could be a mix of bilateral guarantees and loans, help through the EU structural funds, concerted action to buy bonds, etc. In order to push for further reforms, the existing economic and fiscal surveillance mechanisms would be applied, though further conditionality can be attached to loans.

 

The pros

-          This would demonstrate the political strength of the Eurozone in dealing with its internal problems.

-          The IMF would be kept out of the Eurozone which would not only be of symbolic value, but in the eyes of some would prevent the Fund from implementing inadequate policies in the EU (in particular given its weak record of action in fixed currency regimes and the fact that US-preferences, which may not necessarily be in line with continental European considerations, would influence its approach).

-          If the EU’s strategy works, it would enhance the European coordination of economic policies, probably beyond the crisis situation.

-          It would increase the pressure on the EU to pursue a double strategy of immediate crisis management for Greece and the development of a framework in which real economic problems underlying the fiscal troubles in the PIIGs could be discussed. The major problem is the divergence of competitiveness in the euro-area which is not only caused by excessive Southern European wage increases and low productivity growth alone, but also by beggar-thy-neighbour policies pursued by some countries with a high external surplus.

 

The cons

-          The EU does not have technical Know-How, human resources and political independence, in order to grant rescue package with clear and credible conditionality and successful surveillance. In particular, the imposition of conditionality would be very difficult within the EU itself.  The partners are politically too close and economically and financially to intertwined to build up credible pressure if reforms are not implemented to a sufficient degree. Furthermore, European political actors tend to have a bias not to point out detected problems brutally as they may be driven by EMU-image saving concerns.

-          Public opinion might react sensitively, both in Greece and in the supporting countries.
The Greek state and society has lived beyond its means as it was able to rely on heavy borrowing at Eurozone low interest rates and also received substantial EU subsidies. The adaptation process that has now started will be unpleasant and there will be obstacles to implement reforms. Public protest could turn against the Greek government and on external creditors imposing hard conditionality on the country. For the EU it may thus be politically useful to take the IMF along as the bad cop.

-          If a country consortium led by Germany would try to impose conditionality on Greece, strong public and political reactions could be provoked notably with reference to the Wehrmacht occupation from 1941 to 44. This is a strong argument against an aid-package which is predominantly based on bilateral help (hence with a strong role for Germany).

-          If the „EU-only“-approach fails, the costs are potentially high. The EU will firstly have proven its inability to solve an internal problem. This would weaken the EU in the eyes of its partners politically and could cause market reactions as investors may no longer trust that EMU problems can be solved. The EU would secondly risk that emergency credit is turned into transfers - and that further transfers may be needed in order to prevent an insufficiently reformed Greece to go bankrupt at a later date.

 

Our assessment

At the moment, it seems that officials both at the EU and the national level of potential donor countries are very wary to construct a rescue package for Greece without IMF involvement. Especially the argument of a lack of expertise and leverage for pushing Greece into dramatic budget cuts seems to have clout. We therefore believe that an EU-only approach may turn out to be perceived as less attractive than cooperation with the IMF.

In our view the European Council’s decision to take along the IMF in the March mission to Athens during which the European Commission, the ECB and the IMF will review Greece’s reform progress will probably turn out to be useful given the additional experience by the ECB and the IMF. But we think the ECB would do a job that is not hers if the Bank continues to fulfill surveillance functions that feed into the political decision making process of the Ecofin in implementing fiscal surveillance according to Art. 126.  Given the complexity and opaqueness of the Greek situation and the European Commission’s previous problems in dealing with this, we consider taking the IMF in for surveillance and conditionality is the better solution.

 

Option IIb: The IMF is called into the Eurozone in order to help sort out Greece’s fiscal problems together with the EU and/or some member states. The existing EU economic and fiscal surveillance mechanisms would be applied, but further conditionality would be attached to the rescue package.

 

The pros

-          A presence of the IMF in a joint rescue package together with the EU would bring in the necessary technical expertise and more independence which the EU does not currently have.

-          The ability to impose conditionality would hence be increased if the EU cooperated with the IMF.

-          EU officials could benefit from learning-by-doing while the IMF provides basic guidance.

-          This exercise would help the EU to build know-how for running its own EMF, for which the preparations should be launched in parallel.

-          The IMF is used taking the blame for unpopular policy measures. In Greece, it might shield the EU and Germany from people’s anger. The IMF could also be used as a political scapegoat by Greek policy makers.

 

The cons

-          If fiscal adjustment alone is not sufficient, the involvement of IMF money might complicate debt restructuring for Greece. The high level of Greek government debt and the contraction of GDP that is to follow the austerity measures might well drive the Greek debt-to-GDP-ratio further upwards to a level where it is not sustainable anymore. In other words, it is possible that the Greek financial mess is so severe that measures to cut the deficit will not be sufficient to bring public finances back on track. In this case, debt restructuring should be part of the solution. The IMF however, does neither have the tools to mandate or to implement such a debt restructuring. It might even try to get its money back at the expense of other creditors. Its loans would be outside the EU’s jurisdictions which seriously limit the scope for action.

-          The IMF’s record for overseeing adjustment processes in countries without flexible exchange rates is rather unimpressive. In Argentina, the IMF’s recipes proved to be unable to stabilize the government debt trend, but only pushed the country deeper into recession which finally led to an overthrow of the government and a messy default.

-          The IMF is driven by political (mainly US) interests. In the view of some, this may mean that the US may be against pressuring Greece too hard through IMF conditionality, as Greece is a Nato member and both countries cooperate in defense, there is a US military base in Crete.

-          The IMF presence could be perceived as evidence of the Eurozone’s and the EU’s weakness.

 

Our assessment

A combined action by the EU (or some EU members) and the IMF seems to be a likely scenario at the moment. Nervousness about Greece’s manipulation of budget data, the use of opaque financial instruments, etc. have strengthened the perception among civil servants and policy-makers, that effective surveillance is difficult to conduct. Protests on Greece’s streets, the heating up of the domestic political debate and the recent provocation by Greece’s Deputy Prime Minister Pangalos who accused Germany of not having paid adequate war reparations strengthen the case for a “bad cop” from outside the Eurozone.

While from a Greek perspective the recent provocation may have been intended as a move to put pressure on the German government to help out Greece, the effect may be precisely the opposite: German readiness to lead an EU consortium to help Greece may in fact reduce due to the new tone introduced into the debate, in particular as German public opinion is hostile against aid packages and highly critical of Greece’s cheating into the EMU. All this may make an involvement of the IMF more likely.

In order to overcome the EMU’s credibility problem, the IMF’s presence could be limited in time and the EU could assert its ability to act by deciding upon the creation of the European Monetary Fund and an orderly default procedure at the same time as the aid package for Greece is put together.

 

Option III: The EU does not grant support to Greece, but Greece calls in the IMF alone

The pros

-          The No-Bail-Out-Clause of the Maastricht treaty would be respected.

-          There would be no loan- or guarantee-related direct and immediate risks for the other EU governments.

-          The risk that the Greek crisis lessens the support for European integration would be reduced.

The cons

-          The IMF’s record for overseeing adjustment processes in countries without flexible exchange rates is rather unimpressive (remember Argentina and see option IIa).

-          The fact that the EU lets Greece fight for itself would risk a political backlash against European integration in Greece.

-          Given prior magnitudes of IMF programs, it is very unlikely that the IMF will provide a package large enough to secure all financing needs for Greece this year. The austerity program hence would have to be much harsher than the already planned one.

-          If a fiscal adjustment is not feasible and debt-to-GDP-ratios reach unsustainable levels, the involvement of IMF money might complicate debt restructuring (see explanation in option IIa).

 

Our assessment

There is a possibility for this scenario if for some reason the EU does not come to an  agreement over the way how to help Greece. However, in our eyes, severe political mistakes on the side of the EU/Eurozone and its major member states as well as on the Greek side would have to occur in order to provoke such an outcome. The EU’s image would be seriously harmed and questions on inner-European coherence and solidarity would be raised.

For Greece, the required austerity measures most likely would be harsher and the following collapse of the Greek economy more protracted, as the IMF has fewer funds available than a joint EU/IMF package.  If the worst case scenario hits, namely that despite consolidation efforts Greek debt levels are unsustainable and debt needs restructuring, Greece would then in the end be in the danger of having to default anyway – with all the negative direct effect on its economy and people as well as spill-over effects to the other Eurozone members.

 

Daniela Schwarzer is head of SWP´s EU integration division and Sebastian Dullien is Professor at the University of Applied Sciences in Berlin. Together they run the blog Eurozone Watch.

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