Europe in Dire Straits – don’t be Brothers in Arms.

By: Henrik Enderlein

On 30^th October 1975, the New York Daily News titled: “FORD TO CITY: DROP DEAD” - referring to the refusal of the US-President to provide financial assistance to the New York City government (at that time in serious debt difficulties). Today, this headline is a perfect guide to handling the situation with Greece. Instead of muddling through and changing the basic rules of the euro-area, European leaders should now send a clear message and tell markets that there won’t be a bailout for Greece.

For the time being, the recommendation to send a clear “no” to Greece is mainly coming from believers in neo-classical economic orthodoxy. I would argue that believers in stronger political integration and closer economic cooperation should also embrace this position. The EU looks weak if it first signals that Greece is a serious problem and then can’t solve it (or can only solve it by breaking its own rules). The EU looks strong if it can convince markets that the euro-area is sufficiently solid to even accommodate a Greek default.

I know there are many arguments against this position – I can think of at least five of them. But here is why I think they are not convincing, except perhaps for the last one.

First argument: “A no bailout statement would send Greece into a sovereign default.” No. Greek government debt levels are high, but not outrageously high. Many other countries in the world have much higher debt-to-GDP ratios, and they still have access to fresh capital. Even in the context of a clear “no” from EU leaders Greece would have several choice: it could decide not to implement austerity measures and pay the price for it (high interest rates – as in many other cases across space and time), or it could try to convince markets that it really wants to reduce its debt (convincing arguments would be institutional changes in domestic policy-making, tax increases, or wage-restraint). It could also turn to the IMF – and this is the most likely outcome. The IMF could serve as the ropes tying Greece to the mast. Usually, this recipe works: Do you remember the talks about a Ukrainian default being “imminent” in the spring of 2009? Apparently, not every crisis situation translates into a worst-case scenario.

But even a default would not be as devastating as currently suggested.  This brings me to the second argument: “Greece is like Lehman.” No. Even in the highly unlikely case of a Greek default, the shockwaves into the financial system would not be as enormous as often argued. A country is not a bank. A bank either stays alive or falls apart. A country has more flexibility: it can default on parts of its debt, it can enter into negotiations with creditors to roll-over its debt, it can seek to restructure the terms of payment. There are numerous examples of governments working closely with private creditors to bridge a period of financial distress. Uruguay did so quite successfully in 2001 in a pre-default restructuring. The often quoted case of Argentina is an outlier: not every default takes several years until a settlement is reached. Also: the Lehman shockwave was large because of Lehman’s role as a sought-after intermediary for a large variety of financial products. By contrast, Greek government debt is a simple asset. No normal investor should have a disproportionally high exposure to Greek debt. This almost by definition implies that the costs of a Greek default would not nearly be as high as in the Lehman case.

Third argument: “Contagion”. Beyond the points already made above, there simply is no reason to believe that a no-bailout declaration on Greece would push Portugal, Spain, Ireland, and Italy into defaults. Sure, bond spreads would rise, but if history is of any guidance, this would be a temporary phenomenon. Brazil did not default in 2002 after Argentina defaulted, even though it faced strong pressure from financial markets. It teamed up with the IMF and presented a series of austerity measures that ultimately convinced markets. In 2003 Brazil even exceeded the budgetary surplus target set by the IMF.

Fourth argument: “You have to be anti-European to argue against a bailout”. Certainly not – quite on the contrary. The EU, and in particular EMU, would look stronger if they signaled that they could let Greece go. Do the US Federal Government and the dollar look weak as a consequence of California’s debt problems?  No, and the reason is President Ford’s declaration cited above. Adopting a forward-looking perspective, the argument gets even stronger: All the Treaty provisions on surveillance and other pre-emptive measures would finally look credible, as hoped by those who prepared the Treaty (which explicitly excludes the bailout-option – even if some lawyers no try to find gaps in that clause). Ultimately, even the euro might gain. Greece represents around 2% of euro-area GDP and financial market participants just have to realize that the euro’s real value is not determined in Athens.

Fifth argument: “A Greek default is a black swan event”. This is the only argument that could look convincing – even if I do not think it is compelling. The black swan story goes that a non-bailout declaration would trigger unforeseeable and devastating consequences - so given the risks, muddling through or a bailout are more reasonable choices. What proponents of this view overlook are the hidden risks related to the strategy that EU countries are adopting in the current circumstances. Black swan events can’t be foreseen by definition. So trying to avoid them could make things even worse. Isn’t it possible that the current strategy of EU leaders to issue explicitly confusing remarks puts the euro-area and Greece even more into the spotlight? We just don’t know. But I doubt that clarity would make things worse. One should then also take into account that a Greek bailout would set a dangerous precedent in the EU. I call this the “Berlin fallacy”: the city of Berlin has been in a state of bankruptcy for more than a decade but still can access capital markets with a triple A rating. The reason is that the German Constitution asks the German Federal government to be the ultimate guarantor of debt issued by the German Länder. At the same time, however, the German federal government can’t influence policy-making in the city of Berlin, i.e. the city mayor of Berlin can promise free Kindergarten to Berlin families financing this by debt ultimately backed by tax payers in other parts of Germany. Unintended long-term consequences of short-term political or legal considerations should not be taken out of the equation, even if they are by definition hard to predict.

Overall, Europe would look stronger, not weaker, if it sent a clear „no“ to Greece. A currency union that can’t accommodate a default of an economy accounting for 2 percent of its GDP doesn’t look particularly strong.

But ultimately, Greece is only the symptom not the reason for the problems in the euro area. For the past ten years the currency union has wrongly signaled to itself that it could be successful without real instruments of economic policy co-ordination and without political union. The discussion on how to better cooperate has to start again – but against the background of a clear stance against Greece. The main signal of the EU should be that either both rights and duties are located at the European level – or that both stay at the national level. If we leave rights in the national context but shift duties to the European level then we weaken economic integration in the EU.

By the way: The 1975 sovereign bankruptcy of NYC was avoided. The default declaration was already drafted when a Teachers Union stepped in to provide the necessary guarantees. Even the federal government participated in the rescue but could successfully declare that NYC had saved itself. US economic policy making still benefits from President Ford’s clear message.

 

The author is Associate Dean and Professor of Political Economy
Hertie School of Governance, Berlin.

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