Sunday, May 9, 2010

Will the Greek crisis end in tragedy?

The glitterati of the economics profession have been out in full force to comment on the Greek crisis, what with Paul Krugman (, Greg Mankiw (, and Nouriel Roubini ( wading in to give their opinions.

OK, so things have erupted in Europe with the Greek debacle continuing to unfold - but the main question now revolves around 3 things: first, whether the EU bailout ( - I know Germany is contributing to this, but officially it is an EU initiative) is enough to "plug the dyke" in Greece's public finances; second, whether the EU measures will be enough to stop contagion taking place across Europe thereby threatening the euro area; and third whether Greece can remain in the euro area.

I pose these three questions separately on purpose, because as we all know, whether the actual bailout is big enough to stop financial panic is not how financial markets behave - they behave according to fear and irrationality as we saw in the Mexican peso crisis in the 1990s when panic swept across quite a few South American countries that were nowhere near to defaulting on their public debt obligations.  The last question is a matter of politics as well as economics, so I will also address that as it is now on the radar screens thanks to Paul Krugman.

But let's start at the beginning.  In the Maastricht Treaty, which was the original blueprint for the euro area, Article 104 specifies that "Overdraft facilities or any other type of credit facility with the ECB or with the
central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments."  This is known as the "no bailout" clause, and clearly states that the ECB cannot bailout Greece.  But in Article 103a it states that "Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by exceptional occurrences beyond its control, the Council may, acting unanimously on a proposal from the Commission, grant, under certain conditions, Community financial assistance to the Member State concerned." 

So that is what is happening this weekend - the euro area finance ministers are huddled together to hammer out an agreement to effectively lend Greece €110bn through "Community financial assistance" over what is rumoured to be a 3 year period.  At the same time the Greek government has put in place austerity measures to try to reduce it's budget deficit, hence the riots in Athens.  But today there are also signs that the Finance ministers want to "ring fence" the Greek problem by providing an enhanced (€110bn) fund to get Greece, Portugal and Spain through what was the €60bn emergency facility that allowed Latvia, Hungary and Romania to get through their balance of payments difficulties last year.

Let's now go back to the key questions we asked at the beginning.  Is this enough to "plug the dyke" that is the mess with the Greek finances.  The answer is an unequivocal "yes".  First, remember that the Greek economy represents only roughly 3% of the euro area economy.  If you look at the Greek Finance Ministry's last report on public debt (see which rather mysteriously ends at the end of last year, and hasn't been updated yet for Q1 2010) you'll see the following chart (click on it to bring up a bigger version), which shows the redemption schedule and term structure of the public debt in Greece. 
As you can see, total Greek public debt at the end of last year was reportedly just under €300bn with only 10% rollover due to take place in 2010, and 50% rollover required more than 5 years away.  So all this talk about debt restructuring, while it will make it easier for Greece in the short term, is nowhere near the order of magnitude that the media is hyping it up to be.  Now I'm not denying that debt in Greece is high, but at 120% of GDP this really is not wholly exceptional - take a look at Japan, which has debt levels approaching 200%.  But the main point to be made is that the €30bn plus to be either paid off or rolled over in 2010 can be funded through EU borrowings, so the amount provided through the EU is definitely sufficient to avoid a default. 

So to the second question - whether this is enough to stop contagion to the other euro area member states.  Of course what the financial markets don't like is surprises, and the public debt figures are higher for Greece than reported above (as some of the debt wasn't reported and was "hidden") so that the figure of €300bn is actually €356bn  - that, in my opinion, is the main reason for the panic - the financial markets cannot trust the Greek government to report the debt figure honestly or accurately.  Is there a similar situation in Portugal and Spain?  No, there isn't.  So although bond yields have spiked for Portuguese and Spanish public debt, the problem is not qualitatively similar to Greece's, so the concern about contagion is overdone in my opinion. 

As an aside, I'm not saying that there is a linear relationship between debt/GDP levels and financial crisis either, as Rogoff commented a few days ago in the FT (see What matters is that you have not offended the markets recently, and of course a country like Japan (with public debt levels approaching 200% of GDP), even with anemic growth, can still make it's bond payments because of low interest rates due to market confidence. Even a speculator extraordinaire like George Soros doesn't see Greece defaulting on it's sovereign debt. And there is little reason to think that either Portugal or Spain would follow suit even if Greece did.  Of course that doesn't stop speculators speculating on it, and that's exactly what happened at the end of last week (see  Incidentally, I think this is exactly the time to start buying EU stocks as clearly the euro will bounce back once this crisis is over - certainly if I had millions of dollars that's what I'd be doing right now!

So the next question, is whether Greece will  leave the euro area.  Krugman even goes as far as to state, after going through 3 options that Greece would have to consider to stay in the euro area, that "What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left."  I think Krugman underestimates the political will of the larger members of the euro area to keep the show on the road.  The EU has always risen to the occasion when crisis hits, and this time will be no exception.  And let's face it, this is not a crisis of confidence in the euro itself, just a crisis of confidence in the economic policies of one of it's member states, Greece, and in the Stability and Growth pact and it's ability to control public debt issuance in profligate euro area member states. 

So Greece, in my opinion, will remain in the euro area but will face some really dark years ahead, particularly if EU growth does not pick up soon.  The main point I would make though is that the EU needs to start thinking a little more strategically about how the institutional structure of its design can weather different economic scenarios rather than what is the most feasible solution from a political standpoint.  The Stability and Growth pact (see my previous post on this blog) is a perfect case in point. 

There will definitely be a period of deep reflection in EU circles after this crisis is over, and hopefully it will lead to some decisive action, otherwise the EU is doomed to lurch from crisis to crisis, making rushed decisions in response to market forces rather than constructing an EU that is resilient in the face of economic shocks and downturns.

Saturday, May 1, 2010

The SGP ramifications of the Greek Crisis

I was just at a conference of Europeanists in Montreal a couple of weeks ago, and although many of them didn't show because of the lack of transatlantic flights due to the Icelandic volcano ash clouds, there were enough delegates to get a good guage on what Europeanists are thinking about in terms of the future of the European Union and the euro and the ongoing Greek crisis.

The main ramification that I got from chatting with other delegates is that the Stability and Growth Pact (SGP) is essentially dead, with the Greek situation putting the final nail in the coffin!!  The SGP was originally a German idea back in 1997, which was meant to allay German fears that they were giving up their beloved Deutschmark for something not as robust and that they had less control over.  The main condition in the SGP (which was actually just a continuation of the main Maastricht criteria for fiscal policy) was the budget deficit criteria which specifies that member states need to keep their government budget deficits below 3% of GDP. 

Academics like Willem Buiter had already criticized the budget deficit criteria as a little meaningless, not just because it was seemingly an arbitrary number, but also because it is usually debt that matters for fiscal sustainability rather than deficits.  For example you can have a very low debt and then have some kind of event where you need to stimulate your economy big time - Finland went through something like this in the 1990s, and the US is clearly going through something similar right now - so that your budget deficit balloons during that period.  To put this more simply, it is like focusing on the most recent additions to your credit card debt (if you have any!), rather than focusing on the total that you owe.  Clearly the total is the most important figure, not what you've just added to the total. 

The SGP then specified that if you ran a deficit above 3% you would attraction the attention of the European Commission and then a complex process would begin such that you would have time to put your house in order and if you didn't you'd first be sanctioned and then fined.  There were let-outs for recessions and other uncontrollable events, but essentially during normal times a member state's budget deficit was supposed to be under 3% of GDP.

The way the SGP was supposed to work was that governments would report their deficits and debts to the Commission and then they would decide what the situation was, and then the Commission would prepare a report and if any action was needed would pass this on to the European Council for a decision - and some of these decisions were supposed to be almost automatic.  Back in 2004 both France and Germany were found to be violating the 3% limit and the European Council decided to do nothing, violating the spirit of the SGP and prompting some soul-searching on what kind of conditions should allow a member state to run deficits that were greater than 3%.  The so-called SGP II was launched, which was softer on member states when they ran deficits and also had a greater focus on debt, but essentially it was the same "monster", wrapped up in a little more sensible clothing.  But apart from the aforementioned problems, there were other fatal flaws with it ( - described in many of my earlier papers on this topic). 

First, the EU member states did the public accounting to construct the measures needed for the SGP - so as Greek did, you could easily "fix" the figures and the Commission would be none the wiser.  It seems to me that if the SGP was to be taken seriously the Commission should at least have had a representative working in every finance ministry in the euro area.  They didn't.  When the IMF needs to evaluate what is going in a country, a team is sent out - and obviously the veracity of the figures is evaluated at the same time.  There is no Commssion equivalent.

Second, it was all stick and no carrot.  Where was the reward for being good?  With the IMF if you do what they say you get in the form of a loan that you desperately need.  With the European Commission you got nothing more than you otherwise likely would get - so there is basically no incentive to be good.

Third, even if the SGP was mostly stick, the stick was hidden from view, as there was a tacit acknowledgement that the penalties would (likely) never be used - to fine a member state that was already running a deficit seems a little counterintuitive - shouldn't the rest of the EU be helping them, not punishing them?

Fourth, having the SGP gave the financial markets more "comfort" than they should have had, as it probably hindered them from properly evaluating the risk of default from any one member state.  So when there was a realization that the Greek situation was much worse than thought, the yield on Greek bonds really took off. 

So the Greek situation has really broken the SGP - and good riddance to it in my opinion.  Monitoring member states and reporting back on their fiscal situation seems like a sensible idea, but it has to be constructed in a way that makes sense and the SGP never made a lot of sense to me, not only in its essential ingredients, but also in the way it was implemented.

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