Body
The news that Greek 10-year bond yields are now above 7.5 percent—significantly above the rate just before the announcement of a joint eurozone/IMF rescue of at least €30 billion—deals a new blow to eurozone leaders. Financial markets are basically telling them that in rescuing Greece, they may be wasting their money!
Ironically, Greece's misfortunes may include some good news for the region, in that there has been a clear divergence on rates between Greece and the other so-called PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain). This trend suggests relatively limited immediate contagion risk to Italy or Spain, perhaps reflecting their somewhat healthier economic fundamentals. Nevertheless, the governments in Lisbon and Madrid cannot afford to be complacent. They need to change their ways soon if they want to avoid the fate of Athens.
The absence of immediate contagion risk further suggests that the "panic factor" from Greece is subsiding among financial market participants, which paradoxically indicates too that any fallout from a Greek default would be free of "unexpected systemic implications" (unlike the Lehman collapse in 2008). It might be safer than often assumed for Europe's politicians "to let Greece go."
Some argue that the widening of Greek spreads results from an "implementation risk" of the rescue program, i.e., the fear that either eurozone countries' parliaments will refuse to authorize the bailout (like the US House of Representatives' rejection of the Troubled Asset Relief Program [TARP]) or that the eurozone and IMF will not be able to agree on the conditionality terms. But both such concerns, if they exist, are overblown.
Regarding the danger of IMF-eurozone discord, the eurozone is almost certain to defer to the IMF in determining additional austerity measures to be imposed on Greece in 2011 and 2012. Because such measures must cut far deeper than what has been announced, the eurozone will for political reasons let the IMF bring the hatchet to the Greek public sector. The first object of cuts will be public payrolls and the public pension system, which will have to go along with higher retirement ages and cuts in benefit levels for higher income groups. These steps will no doubt deepen Greek popular disapproval, reinforcing the reluctance of Europe's leaders to serve as messenger of the gods of fiscal rectitude.1
As for the problem of parliamentary approval, those eurozone governments facing this requirement—Germany, Ireland, and France, for example—have sizable parliamentary majorities to meet it. Even if it is politically costly for Chancellor Angela Merkel, she has the votes to get it passed.
Given the low level of "implementation risk," one must conclude that the negative market reaction arises from other factors. Instead, markets are signaling that despite the aid package for 2010, they regard Greece as insolvent and in need of debt restructuring beyond the palliative of somewhat lower interest rates.
Once markets refuse to participate in financing Greece's needs, the spiral of death is set in motion, a default is seen as unavoidable, and the eurozone and IMF must face the prospect of meeting the nation's financing needs in their entirety. Beyond the €45 billion cost for 2010, the total needs for official assistance to Greece over a multiyear period would be well above €100 billion. It would be extremely unlikely for eurozone taxpayers or the IMF to provide that kind of money.
As the US government learned with TARP (which was initially rejected and later approved), lawmakers may be cajoled into accepting a bailout if the only alternative is chaos. On the other hand, lawmakers and the public are likely to make that choice only on the condition that the loan recipient promises NOT to come back again and ask for more. Not only that, if eurozone governments approve a loan package without a plan for additional financial assistance in 2011 and 2012, the markets will understand this future problem even if the public at present does not.
The players in the Greek drama, in other words, are setting themselves up for a monumental policy fiasco with potentially far reaching consequences. For months, it has been clear that eurozone members have been acting more to save their own banks from the fallout of a Greek default and less out of a desire to show solidarity with Greece. But by agreeing to an insufficient bailout, the eurozone ensures that the financial losses will likely be seen in Europe as suffered "in the name of Greece," rather than "in the name of German, French, and other eurozone banks" who carry the exposure on their books. (The losses could be enormous—Greece may have to write down more than 50 percent of its debt just to reach debt-to-GDP standards enshrined in the Maastricht Treaty.)
In a financial sense, it perhaps should not matter whether eurozone taxpayers blame Greece or their own banks for their losses. But obviously it matters profoundly in political terms.
The risk is that a Greek default following the initial phase of a eurozone/IMF bailout attempt will be viewed as a betrayal by Greece, rather than Europe's disgraced bankers, deepening skepticism about the European project and aggravating North-South tensions and stereotypes within the European Union. Decades' worth of "performance legitimacy" earned over time by various EU institutions in the eyes of European publics could be lost from this one high-profile policy failure.
Such divisions may not threaten a break-up of the eurozone, but they could force a rethinking of the EU's institutional structure. Public displeasure could also doom any chance to reform the Lisbon Treaty or carry out any additional "fiscal integration." Instead the European public may insist on "punishing" Greece and other errant countries. A bout of recrimination could, in addition, undermine the European Union's growth potential, its standing in the world, and its role as a reliable external partner for the United States and others in the G-20.
Whatever the ultimate outcome, Germany, the Netherlands, and other "strong currency countries" are likely to emerge the winners at the expense of the fiscally challenged and less competitive Mediterranean countries. Their focus will likely turn to devising credible sanctions that comply with the Lisbon Treaty, enforced against miscreant countries.
As the goal of eurozone interest rate convergence recedes, and the Stability and Growth Pact is replaced by new "stick-heavy" enforcement measures, questions arise concerning the European Union's future direction. Traditionally, one of the central "ideas of Europe" and attractions of EU membership was "convergence," i.e., that the new peripheral member countries would achieve growth and welfare improvements as a result of EU structural funds, better governance and more recently the low interest rates inside the eurozone.
That once promising future is gone in the face of the new reality of high interest rates, a loss of structural funds, economic decline, and now the risk of new sanctions under a bailout regime. The glue that holds the European Union together seems to be shifting away from the "carrots of convergence" and gifts from the center, to the "sticks of sanctions" and the prohibitively high cost of leaving the European Union/eurozone, with far reaching consequences for EU unity, coherence, and leadership.
The eurozone would be well advised to think twice before committing to a hasty bailout of Greece.
Note
1. It is perhaps indicative of the reluctance of European Commission officials to participate in this process that IMF officials coming from Washington were apparently able to overcome the "spillover from Icelandic ashes" and make it to Athens in time for the first scheduled joint meeting on April 19, while EU officials coming from much closer Brussels was not.
