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As usually happens when important elections and EU Council meetings are approaching, several events took place in the euro area last week. Despite the generally negative bond market reaction1 to these events, nothing suggests that the euro area is about to fall off the cliff. Indeed, while Spanish and Italian bonds have risen this week, other peripheral bonds have been flat and the semi-core has fallen. As always, elevated bond yields in too-big-to-bailout countries like Italy and Spain represent healthy reform incentives for both domestic and euro area policymakers.
First and most importantly, the Spanish government last weekend finally—as it had run out of other options—bit the political bullet and requested a European bailout of its banking system, while the euro area made up to €100 billion available to the Spanish government for this purpose . The Spanish government finally ran out of excuses to do what it should have done a long time ago and now as a result will lose control over precisely how most of its banking sector will be restructured. This is a good thing for the euro area and Spain itself, but because of short-term factors the bond markets responded negatively.
There is the issue of “subordination,” i.e., the idea that existing private bondholders get pushed down the credit ladder if the bailout money given to the Spanish government comes from the European Stability Mechanism(ESM), a preferred official creditor institution. Undoubtedly these market concerns linger from the restructuring of privately held Greek bonds back in February and March 2012, but the reality is that they do not apply the Spanish context, since they assume a similar event must occur in Spain. Yet, privately, Spanish sovereign bonds will never face a haircut, as such a move would spell the end of the common currency and the European financial system. Consequently, it is safe to assume that every Spanish sovereign bond held outside captive domestic financial institutions would in extremis be purchased by the European Central Bank (ECB) to avoid this outcome.
Then there is implementation risk, which is a far more legitimate concern given the procrastination of successive Spanish governments on the issue of banking recapitalization. For the obvious political reason of wanting to cover up his own complete loss of credibility, Mariano Rajoy has been pushing the case that this so-called capital injection is not really a bailout and would not come with any strings attached. That line of argument however is an easily verifiable myth, as made explicit in the Euro Group Statement noting that “the Eurogroup considers that the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector. We invite the International Monetary Fund (IMF) to support the implementation and monitoring of the financial assistance with regular reporting.”
Since there is quite a lot of euro area money on the line, it is probable that the “implementation monitoring” will be far more hands on than when, for instance, Silvio Berlusconi at the Cannes G-20 in November 2011 agreed to let the IMF regularly inspect the Italian economy. When the independent auditors hired by the Spanish government to go over the books of the country’s banks publish their findings in a few weeks time (probably showing a capital need in the neighborhood of €70 billion to €80 billion), robust financial sector restructuring conditionality should consequently be expected from the euro area.
So while quite a few market participants have sold their Spanish and Italian bonds this week, and potential buyers remain on the sidelines awaiting the Greek elections on June 17th, no fundamental deterioration actually occurred in either Spain or Italy last week.
Secondly, last week’s first round of the French parliamentary elections once again saw the vast majority of the European electorate reject populism. Yes, the rightwing populist French National Front (Front Nationale, or FN) got 13.6 percent of the vote, which is far more than the 4.3 percent they received in 2007. But the FN’s 2012 result is roughly the same as the 11.3 percent it received in the first round of the 2002 parliamentary elections. And yes, the leftwing populist Left Front (Front de Gauche) got 6.9 percent of the vote, which is more than the 4.3 percent the predecessor French Communist Party (Parti Communiste Français) got in 2007. But, the Left Front’s leader Jean-Luc Melenchon only came fourth in his constituency and will therefore not even be on the ballot in the second round elections on June 17th. In reality, the first round elections in France was a big victory for Francois Hollande’s Socialist Party (Parti Socialiste, or PS), which virtually ensured that it will have a governing majority in parliament either alone or together with its traditional ally, the Greens (Europe Écologie, or Les Verts) and will not have to rely on populists to govern. Combined with the fact that the FN has no second round electoral alliance partner and will therefore with certainty not get more than at most perhaps two to four members of the new parliament, it was last week in France again illustrated how continental Europe’s proportional representation electoral systems are perfectly capable of “handling populist parties” and offers them no access to power. In short, the French election results again illustrate how—Greece apart—fears of populism in Europe are vastly overblown. Europe’s voters may keep kicking out incumbent politicians, but they make sure to hold on to largely the same policies.
Thirdly, last week offered a clear confirmation that something is brewing concerning the European banking union. The two key actors in this process, the ECB and Angela Merkel, both implied that this issue is one where they want to see institutional progress—and this matters greatly, because when the ECB and Germany both want the same thing in this crisis, they get it their way. The ECB in its Financial Stability Review of June 2012 made it clear what it wants from euro area policymakers in stating:
...there is a need to go beyond these areas and conceive a banking union as an integral counterpart of Monetary Union. Such a banking union would be predicated upon three main objectives. First, strengthening the euro area-wide supervision of the banking sector in order to reinforce financial integration, mitigate macroeconomic imbalances and, therefore, improve the smooth conduct of the single monetary policy. Second, breaking the link between banks and sovereigns—which significantly exacerbates the impact of any financial disturbance—also by establishing a European deposit guarantee scheme and EU-wide crisis resolution arrangements. And, last but not least, minimising the risks for taxpayers through adequate contributions by the financial industry. These reforms will certainly take time to implement and may require substantive legal changes, including in primary legislation.
Meanwhile, Angela Merkel told the German Bundestag that she is in favor of granting the ECB supra-national regulatory powers over at least parts of the euro area banking sector in noting how: “In Europe it is… about independent oversight in for example the banking sector. I would not mind if the European Central Bank plays an increasing role here, so it gets regulatory powers to protect us from national influences that otherwise make us procrastinate over problems.”2
I will return in a later posting to what we should more precisely expect the upcoming EU Council to deliver in terms of new euro area initiatives, but this week confirmed that the process of creating a euro area banking union is well under way.
Thirdly, this week gave us several additional indications of what potential outcomes we can expect from the imminent the Greek elections on June 17th. Polling in Greece is outlawed two weeks before an election, so relatively little is known about the precise present mood of the Greek electorate and the election is essentially too close to call. However, as I have noted here and here, my base case at probably about 55 to 60 percent probability is that the pro-IMF bailout parties led by New Democracy will win a majority in the Greek parliament. The reason is simple—fear ultimately trumps anger among ageing rich electorates. We saw it clearly in Ireland a few weeks ago, when Irish voters approved the Fiscal Compact Treaty in their referendum and I believe the same logic will (narrowly) prevail in Greece on June 17th. Greeks undoubtedly are sick of austerity, Northern European bossiness, and IMF conditionality, but in the end they despise their own leaders even more and will not again entrust the country or their currency to them. And certainly, the “great Keynesian Hope” in Francois Hollande this week didn’t give them much reason to cheer, as he revealed himself to essentially be in “Germany’s camp.” As a “friend of Greece,” Francois Hollande steely noted on Greek television this week that “I am in favor of Greece remaining in the eurozone but Greeks should know that this requires there be a relationship of trust…..There will be countries in the eurozone that would prefer to see an end to Greece’s presence in the single currency if there is an impression that the Greeks want to distance themselves from the agreed commitments.” Translation: You are on your own if you renege on your reform commitments!
A New Democracy victory, however, will not solve all Greece’s problems, as the Greek government will still, because of the prolonged electoral uncertainty, have failed to implement its commitments under the March 2012 revised IMF program in a timely manner. Given the profound doubts expressed by the IMF in its March 2012 Debt Sustainability Analysis (DSA) about the continued solvency of Greece in case of any program implementation delays, it is consequently doubtful that the IMF would agree to disburse any additional funds to Greece under almost any post-election circumstances. As such, unless the Greek government can work out a new arrangement with the euro area, it remains scheduled to run out of cash perhaps by the end of July 2012. The most likely outcome—unless further politization of the DSA process is deemed acceptable by the IMF Board—therefore would seem to be that the IMF ceases to provide more funding to the Greek government from now on, while probably retaining some sort of monitoring role as part of the Troika. Instead, funding of the Greek government would fall solely on the euro area and the European Financial Stability Facility (EFSF)/ESM. It would be politically quite tricky for the euro area to further increase the financial commitment to Greece to make up for the loss of IMF funding, but ultimately likely doable provided that a functioning pro-bailout Greek government was in place, and it submitted to further losses of sovereignty in the process. As such, while a new pro-bailout Greek government probably could negotiate marginal changes in its existing IMF program, these would be largely cosmetic and not materially subtract from the country’s austerity and reform burden.
It should also be noted that even if Syriza lost the election, it would still with certainty see its voting share vastly increased and become the official “opposition party” in Greece and enjoy a comfortable political position without any governing responsibility from which it could seek to frustrate the new government’s reform efforts. A large Syriza party even in opposition would thus continue to be an obstacle for program implementation in Greece.
A Syriza victory (e.g., status as the largest party with the extra 50 parliamentary mandates that entails) on June 17th would, as I have argued before, not result in a Greek exit from the euro area. Nonetheless this would be a far worse short-term outcome for Greece. First of all, it is unlikely that Syriza would win so big that it would have a majority of its own, meaning it would be required to form a coalition government with other parties. This might be quite difficult for Alexis Tsipras to pull off, as it is not clear that other Greek parties would be willing to enter into such a coalition government with Syriza. The specter of another hung Greek parliament and a possible required third election would thus loom if Syriza became the largest party on June 17th.3
It would however seem probable that the Greek government will run out of cash before a third election could be held, making the formation of a “national salvation/unity/technocratic” government the likely outcome, although it is unclear what such a government could achieve with respect to securing urgently needed funding from the IMF/euro area. A government running out of cash would thus be an almost inevitable outcome of a Syriza victory.
However, this does not mean that Greek bondholders would not be paid and that Greece would experience a second bond default. Instead it seems overwhelmingly probable that the euro area would —through the existing program escrow account—continue to pay creditors on time and keep Greece’s outstanding new and old bonds current. The reason is simple, as most of the holders of these bonds are the ECB (exempt from the March 2012 restructuring) and euro area financial institutions (holders of most of the new swapped Greek bonds). By continuing irrespective of what happens in Greece to pay these bondholders, the euro area would therefore in essence be paying itself and be engaging in a de facto “back door recapitalization” (by preempting any additional financial losses) of both the ECB balance sheet and various euro area financial institutions.
Crucially, however, these continuing payments on Greek debt would occur without the need for parliamentary approval in any euro area capital and hence be politically expedient for all 17 governments and not least Angela Merkel. As such, the political process here is functionally equivalent to what happened in the United States in 1995, when the Federal government had to rely on the US Treasury “slush fund,”—the Exchange Stabilization Fund (ESF)—to provide the money for the Mexican bailout, when Congress refused to authorize this assistance. Indeed, the key political advantage of both the EFSF and especially the ESM is the little noted fact that both vehicles in the name of “timeliness” can (once a new program is initially approved by at least some parliaments, and most importantly, the German Bundestag) disburse money without further parliamentary approval—a circumstance that will be appreciated by any US executive branch official keenly aware that in order to be able to act fast, one must “act outside the reach of Congress.”
Were Syriza to actually assume power in Greece against all odds, it is unlikely that it would survive the experience. Remember that Syriza itself is nothing more than a coalition of numerous far left groupings in Greece, which only registered as a single party a few weeks ago (in order to be eligible for the potential 50 bonus mandates given to the biggest party in the Greek parliament). No one familiar with the age-old tradition for internecine factionalist strife on the European far left would be surprised to read in the “defection letter” of Syriza candidate, Nikos Hanias, to the party leadership sent on June 12th. It read that "It is shameful and dishonourable that by exploiting the justified rage of society, you are gambling with our future, betting on the non-existent possibility that our creditors are bluffing without proposing something if the case is the contrary, especially when you know that your maximalist and surreal positions have no contact with reality." In short, if Syriza were to actually ascend to power it would almost certainly disintegrate as a unified political entity before it could agree on even the most basic requirements of governing, and a sizable share of its new MPs would probably defect to other leftwing Greek parties and likely even switch allegiances to pro-bailout parties like PASOK. In short, Syriza would not remain in power long enough to actively implement any meaningful government program, and the principal damage it will do to Greece (and the rest of the euro area) is passive and arises from the acute uncertainty arising from its rise to prominence.
The end point of that uncertainty, however, is not a Greece returning to the Drachma since that would require the active government implementation of a further destabilizing and complex logistical project. The Drachma will not simply happen accidentally, and is far beyond the capacity any Syriza government, even in the extremely unlikely event that Alexis Tsipras would want to try that route. The end-point after a Syriza victory is a rudderless Greece with no functioning government sliding into economic chaos after being cut off from bailout funds and ultimately ECB liquidity for its insolvent (after a bank run) banks. Rather than return to the Drachma, Greece would slide instead into “being Montenegro”—i.e., passively relying on the euro as a store of value, unit of account, and medium of exchange without access to financial assistance from Europe.
So, even if Greece has been in recession for three years, it provides healthy perspective to recall that Montenegro’s GDP per capita in 2011, according to the IMF’s most recent World Economic Outlook, was just €5,258, compared to Greece’s €19,458. Things can still get a lot worse in Greece—and if Syriza wins—they undoubtedly will.
Notes
1. Note though that the euro FX market this week is flat and equity markets are down just marginally.
2. Original sentence roughly translated by this author in German reads: Deshalb geht es—das kann man an diesem Beispiel exemplarisch sehen—in Europa um unabhängige Aufsicht, zum Beispiel im Bankensektor. Ich hätte nichts dagegen, wenn die Europäische Zentralbank hier künftig eine stärkere Rolle einnimmt, damit sie auch Aufsichtsbefugnisse bekommt, die uns davor schützen, dass nationale Einflüsse uns Probleme verschleppen lassen. Full text of Merkel’s statement.
3. Greek election law stipulates that the leaders of the three largest parties each get a three-day window to try to form a new government, followed by an attempt by the Greek president, after which new elections must be called.
