Europe's Huge €120 Billion Gamble

Financial markets seem to have steadied themselves after the International Monetary Fund and eurozone owned up this week to the fact that Greece will need more than the originally envisioned sum of up to €45 billion in financing aid for the year 2010. Details are beginning to emerge about the likely contents of a multi-year package of up to €120 billion in assistance to Greece.

Under the terms of the new aid, the eurozone and IMF seem to agree to provide Greece with enough financing to cover its refinancing needs for three years, while the Greek government commits to an additional tough austerity program. According to some reports, Athens would implement a 2 to 3 percent increase in the value-added tax (VAT) to 24 percent, a massive increase in the retirement age from 53 to 67 years, abolition of the 13th and 14th month "bonus" for public sector workers,¹ a public sector hiring and wage freeze, closure or privatization of numerous state entities and opening up of perhaps 60 "closed-shop" services professions.

This finally represents some degree of realism from both EU and Greek leaders about what is needed to pull Greece and the eurozone back in the right direction. However, even in the far from certain event that all goes well in the coming weeks for European decision makers, this plan remains flawed and thus represents a huge gamble on Europe's future.

First are the lingering doubts over German parliamentary approval of a higher price tag for the Greek rescue package—now put by Dominique Strauss-Kahn of the IMF at €120 billion for a three-year program.² Tripling the price of an already unpopular measure just a few days before a vote for politicians facing an election on May 9 is not likely to increase support. Moreover, what kind of assistance was Dominique Strauss-Kahn talking about? By statute, any IMF involvement will have "preferred creditor status," i.e., ahead of existing private holders of Greek bonds. It seems that eurozone financing will be subordinate to that provided by private debt holders in an effort to entice private financial market participants to lend to Greece in the longer term.³

However, not only are German lawmakers being asked to bail out a foreign country seen as undeserving because of its past fraudulent actions, they are being asked to put NEW German taxpayer money behind that of private bondholders in the lineup of potential creditors. In other words, German parliamentarians are being asked to bail out both Greece AND bankers and financial speculators (or "locusts" as the latter they are known in Germany). After two decades of the wealthier West Germans effectively transferring money to poorer cousins, the German parliament might seek more conditionality when it votes next week. German parliamentarians (particularly the opposition Social Democrats) may demand that the private sector pay a price in the bailout. But getting an agreement on a deal like that will surely take a long time just to sort out the questions of participation. Would it only be German banks? What about French banks with the largest total private sector exposure to Greek debt? What about participants residing in the City of London or on Wall Street?

While it seems likely that the German government and its parliamentarian leaders will be able to get the Bundestag to approve German participation in the Greek bailout, especially now that Social Democrats and Greens may go along with it, such initial approval sets up serious problems.

With the German aid politically packaged as "a secure loan" to Greece, the assumption is that Greece will be able to pay it all back. However, that is far from guaranteed. Even if the plan succeeds, Greece will have a debt-to-GDP ratio of at least 150 percent by 2012—and only marginally improved medium term growth prospects. Will financial markets lend to Greece burdened by such debts at 5 percent for 10 years, even after it undertakes structural reforms? Almost certainly not! In short, even a successful joint Europe/IMF/Greek government aid program only postpones an inevitable Greek debt restructuring by a few years—at the cost of €120 billion to eurozone taxpayers.

European policymakers must recognize the inevitability of a Greek debt restructuring.  German parliamentarian demands for "private sector participation" is a useful first step towards acknowledging the inevitable. Introduced at this stage in the discussion, however, such a step could lead to additional uncertainty about the German position and financial market volatility next week. German MPS are ultimately right – a Greek debt restructuring must be negotiated with private bondholders and the sooner the better.

The €120 billion buys Europe a window of opportunity to do so, but negotiators must recognize that other eurozone publics expect to get their money back. With any IMF money sent to Greece already guaranteed "preferred creditor status," eurozone political expectations of "politically preferred creditor status" implies that remaining private bond holders could be wiped out in any reasonably sized Greek debt restructuring – such as one that cuts the overall debt burden by half. This issue will continue to make responsible private asset managers avoid any exposure to Greek debt in the future.

Related to this issue is the question of how long Greek sovereign debt will remain eligible as collateral with the European Central Bank's open market operations. How long, for example, can this debt be used for repo-transactions with the ECB? Standard and Poor's have already downgraded Greece to junk-status⁴, and in light of the above, it seems likely that other major credit rating agencies will follow suit. Such downgrading confronts the ECB with a difficult decision.⁵

The central bank must decide whether to again throw out its rule-book on collateral eligibility (as it did at the height of the financial crisis in 2008, when it lowered the credit quality threshold for collateral) and accept Greek government bonds as collateral, even if they are rated as junk. Refusal to do so could trigger a run on Greek banks.

Third is the issue of the German Constitutional Court (Bundesverfassungsgericht), which has the power to strike down laws approved by the German Parliament if it deems them in conflict with the German Constitutions (Basic Law). Any German who feels that his or her fundamental rights have been infringed by a particular law may launch a constitutional complaint, which the Constitutional Court must admit if the claimed infringement of the plaintiff's fundamental rights is of special severity, or if the plaintiff would suffer particularly sever detriment from failure to decide the issue.⁶

A Constitutional complaint against any approval of aid to Greece by the German parliaments has already been announced by a group of German economists,⁷ who claim the bailout violates the "no bailout clause" in the Lisbon Treaty and by extension the German Constitution's requirement for a stability-based monetary policy. Given the nature of the complaint and the sums of money involved, it seems overwhelmingly likely that the German Constitutional Court will accept the complaint.

This raises several headaches for Chancellor Angela Merkel and the eurozone more broadly. Initially, upon acceptance of a complaint, the Constitutional Court must decide whether to suspend the aid to assess whether it was legal or face the risk of later deciding it breached the constitution. If it chooses the former, any German money to Greece could be significantly delayed.⁸

In the past only a small share of German constitutional complaints have been usually upheld (historically just 2.4 percent of all complaints have been upheld by the Court and just 1.9 percent of cases in 2009⁹). But the Karlsruhe-based Court has been noticeably skeptical about Germany's EU participation in recent years. In 2009 for instance, it approved Germany's accession to the Lisbon Treaty but only after demanding that the German government change several related laws.¹⁰ Were the Court to delay the Greece bailout, German participation might be jeopardized.

Fourth is the issue of implementation on the ground in Greece. Will the Greek government be able to carry out the required austerity measures in the coming three years? Greek public opinion already show 65% of Greek voters rejecting more wage and pension cuts.¹¹ A split in Prime Minister George Papandreou's ruling PASOK party between modernizers and traditionalists cannot be ruled out, in which case the country might need new elections. How would the eurozone react to demands for renegotiations from a newly elected Greek government in 18 months?

With the odds so daunting, what is the best way forward for Europe to prevent a contagion spreading from Greece?

Ultimately, if moral hazard is to be avoided, the eurozone cannot be responsible for keeping an insolvent country like Greece afloat. However, the European institutional framework must be able to prevent contagion from undermining other solvent eurozone members and this must include organizing a Greek debt restructuring within the eurozone.

First, it is helpful that Portugal is accelerating additional domestic austerity measures. Lisbon should as a complementing feature immediately approach the IMF to arrange for a Flexible Line of Credit (FLC), similar to the $22 billion FLC available to fellow EU-member (but non-euro member) Poland now has.¹² Given the measures the Portuguese government are already taking, adhering to the IMF's pre-set approval criteria for FLC eligibility should be no problem for the country¹³ and it could hereby secure valuable extra up-front contagion protection. The Spanish government should take similar actions.

Second, as discussed earlier the ECB and eurozone governments must take coordinated action to stem the contagion risk in the eurozone banking system. For example, the ECB could announce its intent to accept Greek government debt as collateral irrespective of its rating status, and act as the principal coordinator of what is likely to be lengthy negotiations over haircuts with private bond holders.

Despite the poor outlook, it is important to remember what would be avoided in such a solution: The eurozone will not break apart from Greece restructuring its government debt. Even though a sovereign debt restructuring would disrupt Greece's domestic banking system, the costs of Greece leaving the euro would be even higher. Changing a physical currency from the euro back to the drachma would not be like moving off a currency peg. It would entail a drawn out logistical challenge that could drive all private capital from Greece as ATM's are refilled all over the country. Similarly, the introduction of a new currency would force every outstanding private debt into default (which is far broader than what will occur from a more limited sovereign default, especially in countries like Portugal with high levels of private foreign debt), as the unit of account is changed.

Greece's advantages from a new currency would be limited. What export sectors would gain? Olive oil? The principal foreign exchange earner in the tourism industry can just as easily gain competitiveness through a reduced price level denominated in euros. And as Rogoff and Reinhardt have pointed out, countries often default and are usually let back into the capital markets after 5-7 years. At that point, Greece's chances for a sensible interest rate will surely be much higher in the euro-denominated markets, when compared to a "new drachma-bond."

In surviving and keeping Greece in its fold, the eurozone will change, its southern flank holding together now only because of the "glue of costly departures," not through any shared vision of stability or economic convergence. It's now increasingly deflationary embrace will fell very cold in Athens and around the Mediterranean in the years ahead.

Finally on the positive side, other developments risk getting overlooked in this southern crisis. There is much better news for the EU to come from the East, where Estonia is all but certain to shortly be accepted as the newest eurozone member, with more Eastern European members joining before 2015. The Greek crisis insures that the euro zone's attractions require countries to do their homework before entering.

Notes

1. Labeling these regular wage payments "bonuses" is reminiscent of the practices in the financial sector, with its multi-year guaranteed so-called "performance bonuses."

2. This week must furthermore have ended any political aspiration that Dominique Strauss-Kahn could have for the French presidency. Having as IMF managing director this week dictated policy terms to the German parliament as the first Frenchman since Napoleon, he has surely achieved something any future French president can only dream of. The question is whether he—like Camdessus in Jakarta in 1997—spoke with his arms folded.

3. Inserting all public money ahead of existing creditors is highly unlikely to entice the latter to lend more to Greece at low rates in the future, as their additional participation would be perceived as highly risky junior debt.

4. See http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245210824601.

5. The ECB traditionally relies on the opinion of four external credit assessment institutions (ECAIs) – Standard and Poor's, Moody's, Fitch's and DBRS, when deciding whether collateral is eligible as collateral or not. In the event of multiple and possibly conflicting ECAI assessments are available for the same issuer/debtor or guarantor, the first-best rule (i.e. the best available ECAI credit assessment) is applied. Or in other words, if at least one of the four ECAIs rates Greek debt as eligible collateral, the ECB can accept it. See http://www.ecb.int/pub/pdf/other/gendoc2008en.pdf.

6. See http://www.bundesverfassungsgericht.de/en/index.html.

7. See http://www.guardian.co.uk/business/feedarticle/9030814.

8. According to data from the German Constitutional Court, 69 percent of Constitutional complaints are decided within one year and 88.7 percent within two years. This suggests that a Constitutional ruling is likely within the duration of the outlined 3-year euro-zone-IMF program. See http://www.bundesverfassungsgericht.de/en/organization/gb2009/A-IV-3.html.

9. See http://www.bundesverfassungsgericht.de/en/organization/gb2009/A-IV-2.html.

10. http://www.bundesverfassungsgericht.de/en/press/bvg09-072en.html.

11. See http://www.bloomberg.com/apps/news?pid=20601087&sid=aDMoEa3OFTr4&pos=2.

12. See http://www.imf.org/external/np/sec/pr/2009/pr09383.htm.

13. See http://www.imf.org/external/np/pdr/fac/2009/032409.htm.