The case for a two-tiered euro
By the time you read this, Greece may have defaulted on its debt. Or it may be preparing to default, but without the D-word. Most likely it will be negotiating another rescue package, but it may still be fighting to secure the latest payment under its existing bailout. Only one thing looks certain as I write. The eurozone crisis will not be over.
It’s been a long, hard journey since the first Greek bailout just over a year ago, a €110 billion loan package from the European Union (€80 billion) and International Monetary Fund (€30 billion) secured by pledges of drastic austerity. A €750 billion European Financial Stability Facility was announced a little later. The prospect of its billions’ being available to any eurozone country that ran into difficulties was intended to “shock and awe” (yes, that term again) the financial markets into calm.
It did not work out. Both Ireland and Portugal have since had to be bailed out. The destructive contradictions of the one-size-fits-all currency remain unresolved. The damage they caused is unrepaired. Then there’s the fact that the very nature of the eurozone leaves its weaker members vulnerable to fears of default. Most of their debt is in euros, and, for all practical purposes, the euro is a foreign currency. Once investors move out of, say, Irish bonds to safer euro debt elsewhere, all that Ireland can do to lure them back is increase interest rates and tighten its belt yet again. If that doesn’t work, the cash will run out.
Belgian economist Paul de Grauwe argues that a liquidity crunch of this type could force an otherwise solvent country into default. Maybe; but in Greece’s case that’s beside the point. The country has, financially speaking, ceased to be a going concern. Neither the 2010 bailout nor the (partial) introduction of austerity measures that are already at the limit of the politically possible have been enough to do the trick. Indeed, by depressing domestic demand, the latter have — at least in the short term — made the budgetary situation even worse. Tax revenues have been hit by the slump in an economy that shrank by over 4 percent last year, and will likely dwindle by another 3.5 percent this year. The conventional response — a massive devaluation designed to restore international competitiveness — is unavailable so long as Greece remains yoked to the euro.
And it’s not easy to break free. Capital controls would be introduced overnight. The Lazarus drachma would collapse in the morning. Inflation would surge the day after. The country would, de facto or de jure, default on its debt (as would a sizeable slice of its private sector). Greek industry would face a painful funding squeeze. Payrolls would plunge, a brutal blow with the official Greek unemployment rate already at 16 percent or so — and rising.
Beyond Greece’s borders, there would be panic selling of debt issued by some or all of the other PIIGS. With a number of EU banks heavily exposed to the PIIGS, an uncontrolled Greek default, and, more dangerous still, its consequences, could conjure up sweaty memories of the financial crisis. And those affected might include the European Central Bank itself. The ECB has been an active buyer of PIIGS debt. Writing down those holdings could be awkward, especially since the eurozone’s embattled taxpayers would be left holding the tab.
But if Greece’s departure from the euro is too risky to consider, that does not change the fact that the May 2010 financing has not worked. And default would be default whether inside the eurozone or out. It’s all very well criticizing the dodgy process by which Greece was admitted into the currency union, and there are few words ugly enough to describe the squalid state of Greek public finances. Nevertheless, for creditors to insist that the country can cut, privatize, and tax enough quickly enough to stave off disaster is to allow indignation to prevail over financial and political reality. Greece lacks the social cohesion (and shared memory of recent hardship) required to weather the kind of drastic “internal devaluation” that (fingers crossed) took the Baltic countries through their recent debt crises.
According to the EU Commission, Greece’s debt/GDP ratio will rise to 166 percent next year. The annual budget deficit will stand at just under 10 percent of GDP. Under the terms of the May 2010 bailout, that number is supposed to fall to 3 percent by 2014. Dream on. On May 30, Greece’s two-year bonds were yielding over 26 percent. The market’s message was clear. Without substantial additional external financing, default was on the way.
Adding to the concern have been worries that Greece might not satisfy the conditions necessary to allow the IMF (more rule-bound, it is speculated, in the wake of Dominique Strauss-Kahn’s departure) or EU lenders to release their next portions of the original bailout funds. You may know if they have agreed to do so by now, but the best guess must be that these monies will somehow reach Athens, even if it takes a new bailout agreement to get them there. If they don’t, that could, within weeks, trigger the “hard” default that no one wants.
Arranging a fresh bailout will be an unpleasant process, thanks not least to politics. After years of restraint at home, financing the feckless abroad has proved highly unpopular in Germany, the EU’s principal paymaster. The single currency has been a boon for the country’s exporters, but its voters don’t seem to care. They never wanted the euro, and the events of the last twelve months have only reinforced their suspicion that their beloved Deutsche mark was replaced with an extremely expensive dud. Forcing through the earlier support for the PIIGS was a nightmare for Chancellor Merkel. To ask this most cautious of politicians to demand yet more from restless German taxpayers is to ask a great deal. And lender discontent, a useful reminder of how little grassroots appeal EU “solidarity” really enjoys, is not confined to Germany. The Austrians are unhappy, the Dutch government is floundering, and anger in Finland over its participation in eurozone rescue parties has helped propel the populist-nationalist True Finns to the top of the polls. A new bailout will only add fuel to these fires. Merkel, it seems, may be preparing to walk through them. On May 31 markets surged on reports that Germany had dropped its insistence that any new bailout should be conditional on bondholders’ sharing in the taxpayers’ pain.
But despite, doubtless, additional austerity measures and fierce mechanisms to enforce them, new rescue packages will do little to solve the underlying structural problem in Greece and, for that matter, elsewhere. They may buy time but, in the end, there is simply too much debt for some PIIGS to repay. If an honest, old-fashioned default is too terrible to contemplate, that leaves three routes to a theoretically more permanent solution.
The first is, basically, what Merkel wants, “restructuring,” a default in sheep’s clothing, albeit one timed later than she would like. This would be designed in a way that allows banks to dodge the write-downs that could bring them low. The ECB is fiercely opposed to this approach, arguing that it will inevitably set off a fresh wave of financial contagion, even a new Lehman. Nouriel Roubini, Doctor Doom himself, disagrees. It is impossible to say who is right. Both sides are, in the end, making guesses about the mood of a perpetually manic marketplace. That said, the ECB’s stance implies the PIIGS will eventually be able to repay all their debt: an idea as implausible as the notion that they might fly.
More probably, the ECB is relying on Brussels to push forward with the closer fiscal and economic union without which no large monetary union can succeed. This has always been on the European Commission’s agenda, but until this thoroughly predictable and most convenient crisis, it had been politically impossible. That’s changing. Fiscal and economic integration has gone farther and faster over the last 18 months than would have been imaginable just a few years ago. The Eurocracy may, despite current traumas, even see this all as a vindication of the great gamble that was taken when the euro was launched half-done. The problem for Brussels is that the events of the last year have left voters in the eurozone core free from any illusion as to how costly such deeper integration — which would essentially establish a permanent funds-transfer regime from north to south — would be. Will they go along? Will they even be asked?
The third, and, I’d argue, best alternative for now — the split of the euro into two, a strong “core” euro and a weaker euro for the PIIGS — is not without its difficulties, but it ought to work. It would give the PIIGS both the devaluation they need and a chance of avoiding default, and, in addition, it should trim some of the “excess” German surplus. This may be the best alternative, but it’s also the least likely. To Brussels such a velvet divorce would represent an unacceptable step back, and that would never do.
Estonia’s anti-euro campaigners compare the single currency to the Titanic. It’s easy to see why.
– Andrew Stuttaford is a contributing editor of National Review Online.