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Despite its failure to reach the fiscal targets mandated by the International Monetary Fund (IMF) this year and next, Greece is certain to get the next tranche of its IMF bailout funding. The reason is that Athens did enough last weekend to comply with the austerity program in the eyes of the euro group and the IMF. Finally, for example, the Greek government and parliament have agreed to begin laying off previously unsackable public sector workers. Measured against Greece's dire economic situation, the government's intention to transfer up to 30,000 public sector workers nearing retirement age to reduced-pay status, effectively forcing them to retire right away, is hardly an overwhelming policy response. But in light of the country's accelerating recession, the political symbolism was clear.
For a country with a ratio of more than 150 percent of gross debt to GDP in 2011, facing a 5.5 percent decline in GDP this year, an immediate layoff of tens of thousands of public workers is unrealistic. It might save the government a bit on wages, but such a move would almost certainly deepen Greece's recession. Far more important is the fact that the Socialist government is now finally beginning to curb traditional Greek machine politics, which guarantee lifetime employment for vast numbers of political supporters of shifting governments. Given that the principal supporters of the Greek socialist PASOK party are found among these public sector workers, a demand for drastic layoffs amounts to asking Prime Minister George Papandreou to commit electoral suicide. Since the Greek government will formally vote for this measure toward the end of October, the euro group has postponed the final release of the tranche for Greece until after this vote. Evidently, Europe is determined to force Greece and PASOK to end or at least limit its corrupt political system. In short, no public layoffs, no money!
More important, no one in Europe (or at the IMF) wants Greece to run out of money in the coming weeks, which could unleash a Lehman-like uncontrolled contagion through the euro area banking system and to other peripheral countries. Until Europe's new enhanced European Financial Stability Fund (EFSF) becomes operational, as early as the end of October, Brussels is naked in the fight against contagion. Accordingly, the European Central Bank (ECB) will likely oppose any policy decisions requiring it once again to shoulder the entire burden of stabilizing the euro area. The next IMF program tranche for Greece will thus stave off such a meltdown at least until December.
With time, Europe can become better equipped to address such contagion, even as Greece continues to slip behind IMF-program targets and sinks ever deeper into evident insolvency. Several decisions at this week's euro-group meeting of finance ministers are therefore worth dwelling on.
At their meeting on October 3, for example, finance ministers discussed ways to mobilize the EFSF more effectively and with more "firepower," while ensuring that member states' parliaments do not have to ratify new expansion of its €440 billion in resources. Thus euro area policymakers can refrain from using politically charged expressions like "turning the EFSF into a bank" or "using leverage." But there ought to be no doubt that leveraging the EFSF is indeed what the euro area has in mind. An optimistic view will therefore be that a "leveraged EFSF" of some form can be proposed and adopted (without the need for parliamentary approvals, but requiring ECB consent) at the next EU Council summit on October 17–18. This will be after all member states are scheduled to have finished their parliamentary approval procedures for the July 21 agreement. A "leveraged EFSF" could thus fulfill the request to Herman van Rumpoy, president of the European Council, from the previous summit in July to provide "concrete proposals by October on how to improve working methods and enhance crisis management in the euro area."
Various methods exist to leverage the EFSF. Which version euro area leaders choose remains to be seen. It is clear, however, that any leveraged EFSF must have access to the ECB's unlimited balance sheet to have ultimate market credibility. This means that the central bank will have to be an integral part of this task. Agreeing to participate in such a scheme would be outgoing ECB president Jean Claude Trichet's last important task before Mario Draghi succeeds him on November 1.
It would make sense for the ECB to hand over to the EFSF the responsibility for secondary market interventions and enforcement of conditionality, even if the central bank remains the ultimate provider of financial liquidity. Obviously, in such a scheme, the ECB and the EFSF should be concerned about their independence and insulation from the kind of political pressures that undermined the Stability and Growth Pact (SGP) in 2004–05. Thus the ECB might well insist on a series of objective "policy rules" dictating when the EFSF could launch secondary market interventions in support of a given country. Such a step might remove at least some of the controversy about the timing of such interventions and reduce the risk of political influence. The EFSF could, for instance, be licensed to launch secondary market interventions only if a country saw spreads of more than 400 basis points above the euro area benchmark yields—and of course only if the country in question agreed in advance to submit to some sort of conditionality in return for help.
Such a sizable tolerated spread would continue to exert substantial market political and economic pressure on individual country governments to undertake reforms—e.g., Prime Minister Silvio Berlusconi of Italy and his successors. The ability to defend such a threshold of 400 basis points would work only if EFSF can rely on the balance sheet of the ECB. Otherwise, the euro area would set itself up for a repeat of the 1992 fiasco in which Britain tried to defend the pound against speculation with limited resources. EFSF-led interventions would thus be a crisis-only measure, suggesting that conditionality would be tougher and completely automatic.
Euro area finance ministers also discussed the design of "private sector involvement" (PSI) for Greece, the term used to describe haircuts to be accepted by creditors. The ministers clearly indicated that they will reopen the deal they set in July. Citing changes that have occurred since then, including the deteriorating of the global economy and Greece's own economic prospects, euro area leaders seem intent on making private creditors share the additional cost of Greece's bailout. Financial markets should thus expect the Greek government to again approach the Institute of International Finance, the main association of the banking industry, as well as other private creditors, with a "new offer" of a bigger haircut that would not amount to a full scalping. Given the perilous state of Europe's banks and their reliance on public support, it seems unlikely that euro area banks, at least, can refuse.
Then there is the issue of whether various euro area banks will be recapitalized any time soon. Euro area finance ministers discussed the issue on October 3, and such a step should be undertaken to restore the confidence of financial markets increasingly worried about counter-party risk and unwillingness among banks to lend to one another. Spain dipped a toe into this cold sea a few weeks ago, when the Bank of Spain/FROB took over three more Spanish Cajas. Franco-Belgian-Luxembourgian Dexia may be next.
The next round of public assistance to euro area banks will not likely be of the "silent format" implemented in 2008–09, taking the form of government loan/asset guarantees and other non-diluting support measures.1 Today, the politics of bailouts looks likely to dictate direct public capital injections, which would dilute the value of bank shares in the euro area. Governments ought to be keen to secure assets (e.g., bank equity holdings) in return for injecting public money into their banks, to avoid a dramatic increase in their net government debt levels.
With the EFSF soon to become operational and able to provide a backstop for such interventions, several euro area banks might soon find themselves controlled by national governments. Given the need to preserve EFSF capital and the likely desire of national governments to retain control of their domestic banks, most of the capital in any bank recapitalization drive looks likely to come from national sources in the core countries. The EFSF would probably only provide additional capital over certain thresholds to avoid individual euro area members suffering from the Irish fate of having to take over bank liabilities in their entirety and perish in the process.
In sum, Europe looks likely to avoid disaster in the coming weeks and may quite possibly be heading in the right direction in this crisis. But volatility is guaranteed in the weeks ahead.
Note
1. Dexia Bank may here be an exception, as it is already majority-owned by the French and Belgian governments and various local government entities and state controlled companies. According to the most recent Dexia annual report, French and Belgian governments each hold 5.7 percent, the Belgian regions another 5.7 percent, the Belgian public finance vehicle Holding Communal 14.2 percent, and the French state-owned Caisse des Depots et Consignations (CDC) and SNP Assurances 17.7 and 3 percent respectively. Consequently, governments may not wish to further increase their shareholding and dilute private shareholders further to perhaps facilitate reselling Dexia back to private investors at a later stage.
