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Victoria Marklew

Victoria Marklew

Victoria Marklew is Vice President and International Economist at The Northern Trust Company, Chicago. She joined the Bank in 1991, and works in the Economic…

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Can the EU Fix Greece?

The Greek parliament has passed the latest austerity package asked for by the IMF/ EU, and has approved the implementation legislation spelling out the various steps in detail. The markets have heaved a sigh of relief, comforted by the assumption that a new "bailout" plan is in the works. However, nothing has fundamentally changed: Greece is still facing an unsustainable debt burden and the various agencies of the European Union are still unable to come up with a coherent approach to the financial and structural challenges facing many member states.

The European Union is at heart a political project. Back in 1951 the six-member European Coal and Steel Community (ECSC) was founded as a way to tie the economies of France and Germany so closely together that they would never again go to war. The ECSC morphed into the European Economic Community (1957), the European Community (1967), and the European Union (1992) and new members were added along the way. In 2001 came the launch of the common-currency Euro-zone. Critically, each evolutionary step was seen differently by the various countries involved, and each new member joined for its own reasons. In addition, those idealists hoping for a federal Europe assumed that political unification would follow market integration; the anti-federal types saw the creation of a single market as an end in itself.

Humphrey chuckled... "We went in [to the EEC]" he said "to screw the French by splitting them off from the Germans. The French went in to protect their inefficient farmers from commercial competition. The Germans went in to cleanse themselves of genocide and apply for readmission to the human race." -Lynn and Jay, 1984: The Complete Yes Minister. P.273

The above quote may be dated, but the sentiment is revealing. Today, we have a Union of 27 members and a 17-member currency zone, but each one of these countries sees "Europe" as something different. And that lack of political unity lies behind the ongoing debt saga plaguing the Union.

In May 2010 the Euro-zone, led by heavyweights France and Germany, moved quickly to set up the (temporary) European Financial Stability Fund (EFSF) and the bailout package for Greece. The EFSF approach assumes that the key problem to be solved is one of short-term liquidity, but Greece's real problem is one of solvency. The Greek sovereign will not be able to return to the markets to fund itself in 2012 as envisaged in the first bailout, and is highly unlikely to be able to do so in 2014 either. The level of sovereign debt is too large to be sustained by such an inefficient economy and the nation's banks are only being kept afloat thanks to infusions of funding from the European Central Bank.

However, a 17-member currency union is ill-placed to tackle long-term structural reform issues in a member state. This is not news to anyone. Back in the 1990s when the currency union was first being negotiated, the EU members signed up to the Maastricht Treaty. This laid out very precisely the five criteria that a country must meet in order to adopt the euro. The subsequent Growth and Stability Pact specified what sanctions would be imposed if a member failed to keep its fiscal house in order. Almost immediately, the Maastricht rules were fudged to enable Belgium and Italy to join the Euro-zone in 2001, despite their high levels of public sector debt. It was politically difficult to exclude two founding members of the original ECSC from the first wave of adopters. In the mid-2000s France and Germany, faced with rising fiscal deficits, pushed to weaken the provisions of the Growth and Stability Pact. Neither Paris nor Berlin was prepared to tackle the domestic political costs of fiscal reform.

And this, in a nutshell, is why the EU as an organization is treating the European debt crisis as a short-term liquidity problem rather than a longer-term structural solvency issue. No French, German, Irish or Greek politician is going to see him/herself as European first and French/German/Irish/Greek second. National electoral dynamics determine the politicians' perspectives. Thus, French President Sarkozy this week was quick to announce a proposal by which the major banks can "voluntarily" refinance their holdings of Greek government debt. No-one has yet agreed the precise parameters of such a deal, and the details could take months to negotiate, but Sarkozy is facing a tough re-election fight next year and the French like their presidents to be seen to be taking the lead on international issues. Conversely, German Chancellor Merkel has appeared hesitant over the past few months, a result of trying to mollify the rising tide of anti-bailout sentiment among German voters in a year when her party is facing some tough regional election races.

And in Greece itself, PM Papandreou is facing his own national political pressures. Two decades of steadily rising standards of living and protected state jobs have suddenly come to a halt and voters are incensed. The spending cuts and reform measures being demanded by the EU and IMF will exacerbate the recession in the near term. Yet, even if all the steps were successfully implemented it's not clear that the result would be a vibrant and competitive economy by 2014. Such transformations take time plus a strong national consensus that the end result will be worth it. Germany took over a decade to recover from the economic shock of reunification, but the Greeks are being asked to undertake a comparably difficult transformation in just three years. And clearly, there is no national consensus in Athens over the need for austerity and reform.

The actual amount of Greek government debt currently in question is not very large relative to the size of the Euro-zone economy as a whole. Nor does any one European bank hold a level of Greek debt that would be particularly burdensome in the eventual of a default and haircut. Although the ECB clearly is getting tired of being the sole source of support for the Euro-zone's banks and is concerned that its much-vaunted independence has already been compromised, it will continue to act as effective lender-of-last-resort for the 'zone. Despite breathless predictions that a Greek sovereign debt default would cause market seizures as happened in the immediate aftermath of the Lehman Brothers' bankruptcy, the ECB now has liquidity support mechanisms in place to counter a drying up of the money markets and the U.S. Fed and other central banks have just announced an extension of the "temporary" U.S. dollar liquidity swap arrangements established in May 2010 through August 1, 2012.

So why are the markets so nervous about a potential Greek sovereign debt default? Much of it is sheer nerves about the uncertain impact of contagion - those pesky 'unknown unknowns.' But we suspect that the anxieties about Greece mask a deeper concern. During the first decade of the Euro-zone's existence market players treated all members of the 'zone as if they were "Germany lite." Now, many are realizing that some countries still have to tackle long-term structural issues. The challenges facing Portugal, Ireland, Spain, and Italy are very different from each other and from those facing Greece. But the EU, with its 27 politically-myopic members, is ill-equipped to deal with fundamental solvency issues.

Today, the headlines suggest that the Greek liquidity issue has been solved. However, the sovereign still has solvency issues - it will soon face a new series of financing deadlines with a number of three- and six-month Treasury bills maturing in July and August; and on August 20th a €5.9 billion five-year government bond matures. Furthermore, PM Papandreou has said he will hold a national referendum in the fall on proposed electoral changes, which is likely to become a test of support for the government. There are thus plenty of possibilities in the coming months for markets to re-visit the stress of the past few days.


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