Earth to Europe—Get Real! And Why the IMF Should Now Focus on Portugal and Spain

April 28, 2010 5:45 PM

On the day that the Greek debt starts to spread to Portugal and Spain, and Standard and Poor's predicts a 50 to 70 percent haircut on Greek debt, what is the official response in Europe? Simply disastrous!

Spain, the holder of the European Union's rotating presidency—in time-tested EU fashion—calls an EU Summit to discuss the issue—on May 10, two weeks from now. Considering that Greek bond spreads have risen 15 percent in a matter days, it is hard to take such a proposal seriously. Moreover, pushing the date to one day after the May 9 German regional election once again illustrates the failure of EU policymakers to grasp the situation, which they mistakenly still see as less important than placating domestic political concerns in Germany. Hopefully today's downgrading of Spain itself to AA by Standard and Poor's will focus minds in Madrid!

The Greek authorities took drastic action to reverse the situation ... by banning short-selling of shares on the Athens stock exchange until June 28 . Should one cry or laugh?

The President of the EU Council, Herman van Rompoy and ECB president Jean-Claude Trichet echo earlier comments by the Greek finance minister that "any talk of a Greek debt restructuring is off the table." Any senior non-Greek policymaker1 making such a claim should be forced to clean out his or her own desk.

Meanwhile, in Berlin Chancellor Angela Merkel of Germany gathered the heads of the OECD, ILO, WTO, IMF, and World Bank to issue a self-congratulating statement, noting how "International policymakers have countered the global economic crisis with determined and coordinated action...." That would be yesterday's crisis presumably?

On the sidelines, IMF director Dominique Strauss-Kahn (known as DSK) and ECB president Trichet met with the German parliamentarians and—according to participants in the meeting—suggested that the total cost of the jointly negotiated Greek plan would be €120 billion over several years. In other words, acknowledging off the record that the previously discussed eurozone-IMF plan of €45 billion is totally inadequate. One wonders if a threefold increase in the total cost estimate for a Greek package will help sway the opinion of skeptical German parliamentarians.

In any case, for there to be a multiyear program, the real battle ground for the German government is not likely to be the Bundestag but the German Constitutional Court in Karlsruhe. During a three-year period, the Court would be almost certain to have time to issue a ruling about the constitutionality of German government participation in a Greek rescue plan. Even for people without training in German constitutional law, it would seem likely that an increasingly EU-skeptic Court would reject sending German taxpayer money to Greece as a violation of the "no bailout" clause in the Lisbon Treaty and hence also against German law.2 The legal basis for German participation in a multiyear program thus looks shaky.

Angela Merkel and DSK did, however, agree to speed up the negotiations about the joint program for Greece. Literally too little, too late.

DSK further had an interesting answer to the press when answering a question about the likelihood of loans to Greece being repaid. He stated that there is "no absolute certainty in the world, but that no program from the IMF hasn't been repaid in the past." This suggests that the IMF leadership does not rule out eventual debt restructuring but would likely demand its usual "super senior creditor status" if that happens. This could force a larger write-down on other private creditors—not likely the assurances the financial markets were looking for.

What is the road forward now?

The most important thing is to stop the contagion from Greece. With 2-year bond yields of 24 percent, Greece has burned to the ground and it is time to prevent the fire from spreading. European leaders must immediately acknowledge that debt restructuring is inevitable for Greece and that they are aggressively dealing with the consequences of such an action.

Two types of fallout from a restructuring must be addressed: country contagion and the financial system.

First, Portugal and Spain must announce significant new policy measures to rectify their fiscal position. Fortunately, the Portuguese government has realized this and seems to be moving in this direction with accelerated plans to increase high-income and capital gains taxes, new road tolls, and spending cuts on unemployment and other welfare payments. Hopefully, Madrid will make similar announcements.

Both countries have substantially better economic fundamentals than Greece and thus may be able to address this situation if they act decisively and expeditiously.

It would be of further help if both countries swallowed their political pride and went to the IMF to begin negotiating a potential precautionary credit line similar to the $47 billion arrangement for Mexico in April 2009. Both Europe and the IMF are wasting valuable time haggling over money to the lost Greek cause while ignoring the fire that is spreading.

The Obama administration can help tremendously by calling for the IMF to focus on Portugal and Spain and not just on Greece.

To address the second fallout—global financial crisis, which could occur once a debt restructuring is announced—eurozone governments must once again be willing to guarantee or recapitalize parts of their domestic banking systems.

The role of the ECB here will be pivotal. As explained earlier, it seems reasonable to believe that very large parts of Greek government bonds have now found their way onto the ECB balance sheet as repo collateral.

Much of any immediate liquidity shock from a Greek restructuring can likely be averted by the ECB not forcing eurozone banks to put up extra collateral in place of Greek bonds now in default, but instead continuing to accept such bonds. In the longer term, the distribution of losses between the ECB (i.e., eurozone member states) and private banks would then have to be negotiated. Undoubtedly a drawn-out and messy negotiation would be preferable to another freeze of the financial markets.

Expecting the ECB to do more than provide this type of admittedly unorthodox liquidity support through its collateral system is unrealistic, although the central bank would be forced to loosen its collateral provisions if more credit rating agencies downgrade Greece to junk. The ECB is banned from buying government bonds directly and would surely resist calls to do so outright in the secondary market.

Finally, it should be clear that while debt restructuring offers Greece the least bad option for the future and lets it shed parts of its debts, the consequences will be extremely painful for the country and inevitably lead to double-digit declines in living standards. This route to Ithaca will be as long and painful as for Odysseus himself.


1. That Greek politicians would seek to talk up their own bonds despite the evidence is to be expected, but that others should echo this "used-car salesman" talk is irresponsible.

2. The claim put forward by some EU policymakers, including Commission President Barroso, that the loans to Greece do not constitute “a bailout” in a legal sense as they do not affect creditors’ borrowing costs, simply defies common sense. The “no bailout” clause was put in place to constrain borrower behavior and limit moral hazard and has nothing to do with the borrowing costs of the creditors.

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Jacob Funk Kirkegaard Senior Research Staff

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