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It's All Greek to Me FAQ, Part I: Power of Commitment

posted by Anna Gelpern

This follows on Stephen's post earlier in an effort to help sort through the Greece-Goldman-Germany love triangle and the deafening din surrounding its implosion.  This post sets out the background for the Greek crisis, mulls law as a macro commitment device, and the relative merits of EU and IMF bailouts.  The next one goes into more depth on Goldman and derivatives.

Why is everyone talking about Greece?

It’s the Olympics! (Did You See the Inflatable Beavers?)  And because Greece needs to come up with Euro 20 billion (about $27 billion) by April-May to roll over maturing debt.  Greece is having trouble borrowing the money because its debt stock is pushing levels that help poor developing countries qualify for official debt relief, with little prospect of going down.  As a result, Greece may have to pay a 4% premium over Germany, if it can borrow at all.

So what?  What happens if Greece defaults?

When a government defaults, two big things can happen.  First, its creditors—critically, domestic banks, but also foreign banks, bondholders and sometimes foreign governments—lose money and might go belly up.  They say most of the Greek debt is held by European banks, though with derivatives and all, hard to tell where the true economic interests lie.  Second, the Markets get scared, and try to break up in a hurry not just with Greece, but with people and things that rightly or wrongly remind them of Greece (Spain, Portugal, Italy, Ireland, California, the letter G, and the neighborhood souvlaki stand).  This could produce concentric circles of collateral calls, asset sales, price drops, credit contractions, business failures and job losses far, far away from Greece. Even if you could care less about Greece (which would make you heartless), this is the last thing you need in a fragile global recovery.

OMG.  How did it get so bad?

Hard to tell without getting existential.  Greece has had budget and debt problems for over 100 years.   In the immediate case, if Greece had been a regular country, it might have tried to grow its way out of trouble by devaluing its currency, causing tourists to stampede to the Acropolis gorging on souvlaki and generating tax revenue.  But Greece cannot do that, because in 2001 it joined the European Monetary Union, and dropped the Drachma for the Euro—a strong common currency managed by the European Central Bank.  This made it cheaper for Greeks to import German cars.  But it made it harder for Greece to draw Germans to the Acropolis with a sale on souvlaki.  Latvia's so-far successful effort to adjust without abandoning its currency peg to the Euro shows the magnitude of the political effort required:  drastic budget cuts in the face of a GDP contraction over 17% and near 23% unemployment.  You too would tea party.

Why would anyone limit their options in crisis? 

Because some reasonably see the benefit of the occasional devaluation option as limited compared to that of integrating in the vast European market, and riding the general confidence in the stable European currency associated until recently with German budget discipline, not Greek debt history.

In any event, joining the Euro was also supposed to end the history.  This is because as a condition to joining, Greece promised to get its budget deficit and government debt in line with the European targets of 3% and 60% of GDP, respectively.  As this was a legal, valid and binding commitment made under a bona fide international treaty, people and markets could sleep soundly.

Are you being snide?

Yes.  Saying so rarely makes it so.  Argentina had a law that said one peso was worth one dollar.  The United States issued debt that promised payment in gold.  Both promises lasted until they didn’t.  This is not to say that law is not a commitment device, but that it has limitations.  When the enforcement and reputational cost of breaking or changing the law is dwarfed by the cost of economic collapse and social unrest, the law gives.  And it should.  As the apocryphal saying goes, now we are haggling about the price.  But price is very important.  I will address this later in a post about Ecuador, Iceland and Greece (until then, see Adam Feibelman and Mitu Gulati at Faculty Lounge).  Be that as it may, after almost a decade in the Euro Area, Greece’s budget deficit is 13%, and its debt is on track to hit 120%, of its GDP.

So who will save us from the apocalypse, and how?

Apart from Percy Jackson, Batman and another credit bubble, there are two basic options.  Option 1 is for Europe and/or other Member States to give or lend Greece the money to pay its creditors.  Option 2 is to send Greece to the International Monetary Fund, which has a well-developed line of business doing just this sort of lending.

Problem 1 with Option 1 is that German taxpayers feel about the same about Greece as U.S. taxpayers feel about their brethren of the foreclosed McMansion.  People who call themselves taxpayers tend to have little patience for arguments about network externalities (we all rise and fall with the tide) and may not feel the musketeer spirit (even their names were Greek!) for the profligate.

Problem 2 with Option 1 is that the Maastricht Treaty (via the Lisbon Treaty) has a no-bailout covenant, which has received much press coverage courtesy of German politicians:

The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State …  A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State … [Art. 125, Sec. 1 of the consolidated treaties]

To this complete outsider, the prohibition is oddly narrow, drafted to address mandatory assumption of debt.  All manner of financing including guarantees may not be covered, which may explain the private lending options being mooted, discussed below.  Moreover, there are at least three other treaty provisions that suggest that some form of support may be forthcoming if the right parts of the EU apparatus jump through the right procedural hoops.  No doubt the no-bailout clause saved some serious face for some treaty negotiators, but our own experience with Section 13(3) of the Federal Reserve Act suggests that legal texts acquire a special hue in crisis.  If I get enough on this, I will do another post with questions for the EU law experts out there.  For now, this Issing-Padoa-Schioppa exchange is central banking at its most poignant.

Option 2—going to the IMF—has found favor with the internationalist set, but it too has problems.  First, it is mildly to very embarrassing for the EU to send Greece to reform camp outside the home.  It feels like a status knock-down: since the 1970s, going to the IMF has marked the boundary between governments and sovereigns that I discussed in my earlier post.  FT muses on the subject here. Governments take care of their own business; sovereigns flee to the IMF and hide assets from suing creditors.  In fragile markets, the EU and others on the government side of the bright line might want to hang on to the illusion.

Problem 2 with Option 2 is more interesting.  Emergency (aka bailout) funding usually comes with unpleasant policy strings attached.  Who should pull the strings is an important political question, not just for Europe but also for the Obama Administration.  Stipulate that the string-puller is trading off popularity for a measure of control over the Greek policy program.   Germany might want more certainty that Greece would fix its budget, but it risks fanning uncomfortable political flames (see Kim Krawiec’s Nazi post and references).   The IMF comes with its own political baggage, but surely snagging a high-end case like Greece is an institutional boost of Olympic proportions.  As for the United States, the largest shareholder in the IMF, the upside is less clear.  All things equal, I don't want us implicated in Greek policy making, and want more love in Europe as the dollar goes up and I go shopping for shoes and souvlaki.

For now, the leading EU option is to avoid both sets of hard choices, but to get the already-over-exposed European banks to tide Greece over, perhaps with explicit guarantees from Berlin, Paris, et al., which are apparently no problem under the no-bailout clause.  This sounds a bit like the 1980s, when the U.S. government nudged the most exposed U.S. banks to roll and top up loans to Latin American governments while regulators forbore, until Nick Brady, David Mulford & Co. hit on a mix of debt reduction, public and private concessions that made for a more durable fix.  Let us see how long this one lasts.  There is always Percy Jackson.

As for the Olympics—what did people think of the stiletto Mounties act

Comments

Excellent post, very clear. That's why I contend that the solution is more integration in the EU framework. Unfortunatly as you write the leading EU option is to avoid sets of hard choices. I suggest at http://mgiannini.blogspot.com/2010/02/too-little-to-fail-or-when-you-do-not.html a nice way to get out of this crisis and give a strong signal to markets, particularly speculators. A EU financial transaction tax which would raise a large sum of money painlessly, and would help to limit the sort of speculative attacks against the euro-zone.

Moreover funds collected under a financial transaction tax (a kind of VAT at EU level with a Pigouvian character) could also, via a EU fund (European Monetary Fund ?), cover the issuance of EU bonds.

Thus the most effective solution to the present EU sovereign debt crisis would be to issue jointly EU bonds to refinance gradually all the maturing debt of Greece and other PIGS. This would not only significantly reduce the cost of financing of PIGS debt, while creating a EU bond market, but it would replace any International Monetary Fund role and/or conditional loans.

The devil is in the details of the above scheme which would in any case comply with treaties. Euro bond can't solve all problems of deficits, but a common, joint and/or coordinated issuance and use of EU bonds (including recapitalization of banks, European budget, common guarantee funds, EU projects, rescue loans and packages, IMF resources, etc.) could also create an efficient and effective bill or bond euro zone market. Different arrangements could then be studied concerning the issuing institution (single issuer) or coordinated agencies and its guarantees. A bond clearing house, i.e., a vehicle for sharing information to improve fiscal coordination could also be set up under EU umbrella. Some of the technicalities and arrangements would be the same as for the introduction of the Euro as a common currency.

Great stuff -- looking forward to part II. I think an additional aspect of the IMF issue is the potential for US popular resentment. It would not take too long for various members of Congress to connect this to the French and German banks that received AIG money, Germany's refusal to work with the Administration on a joint stimulus effort, etc.

Hilarious! Your writing, not Greece's situation. I look forward to the Ecuador/Iceland article. Between this and Stephen's CDS article, I feel like I understand it again. I would like to see a longer discussion about the IMF and why the US would be concerned about lending to Greece (i.e. what proportion of total IMF funding would that encompass; how much more uncertain is it that Greece would pay back than the other "poor" countries?).

The Greek debt crisis virus is now prone to be infecting the eurozone leading to fears that the crisis will spread to other eurozone nations like Spain, Poratugal, Italy or Ireland. Engineered by the same financial group involved in provoking the US supprime mortgage crisis, chances stand that the Greek debt crisis has a big potential to destabilize the EU but also to kick back to the US economy as well ... The world economies and finances are so interconnected within the global economy, that it became literally impossible for a financial shock like the one in Greece to remain without consequences for the other (remote) countries as well ... Stay tunes for what will happen next, and how EU will decide to go about it - the issue might reveal some interesting aspects and connections

The Greek political leaders are pretty much responsible for this quagmire they are into. They failed to enforce tax collections while overspending their budgets, thus raising Greece's debt to 12% of GDP, which is 9% higher than the limit set by the nations using the Euro.

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