Greece: what about a few months from now?

What’s at stake: When they announced their provisional rescue package for Greece on Sunday, European officials pointed not only to its size but also its details. For euros and details is what the markets have been demanding these last weeks. Yet, there still seems to be a fair amount of confusion about the mechanism and how it will be activated. Greek bond yields are rising again against worries that the Greek aid package will not pass through the parliaments of other European countries. More down the line, it remains far from clear how Greece will deal with its solvency issue.

Activating the package

Felix Salmon writes that though this weekend's EU deal told us more about how a rescue would work, it didn't tell us when, or under what circumstances, the Eurozone would feel compelled to turn on the money spigot. All 16 members of the Eurozone would have to agree to activate the package before Greece would get any loans. 

Zero Hedge reports four German professors are preparing to ask for a constitutional court injunction to block the transfer of German funds, claiming the EU-IMF rescue for Greece violates the "no-bail-out" clause of the EU Treaties. The legal challenge has far-reaching implications. It threatens to cloud the issue for weeks or months and may ultimately force Berlin to withdraw support, raising the risk of wider systemic crisis in Southern Europe. Jacob Funk Kirkegaard argues that their action may not block the initial German disbursement in 2010, but it might impede German participation in the next two years. The aid could thus turn out to be a gun loaded with just this one bullet.

Simon Johnson has a déjà-vu scenario for the coming months. The Greek will now (1) lobby for a large multi-year program from the IMF.  They’ll want a path for fiscal policy that is easy in the first year and then gets tougher. (2) When they reach the tough stage, can’t deliver on the budget, and are about to default, the Greek government will call for another rapid agreement under pressure – with future promises of reform.  The eurozone will again accept because it feels the spillovers otherwise would be too negative. (3) The Greek hope is that the global economy recovers enough to get out, but more realistically, they will start revealing a set of negative “surprises” that mean they miss targets.  If the surprises add to the feeling of crisis and further potential bad consequences, that just helps to get a bailout. (4) The Greek authorities will add a ground game against the European Central Bank, saying things like:  “the ECB is too tight, so we need more funds”.  We’ll see how that divides the eurozone.

No permanent solution in sight

Models and Agents write that Europe’s bazooka is not enough. As it happens, the European backstop alone does not provide a permanent solution. This is because it continues to treat the Greek crisis as a liquidity problem, when many in the markets believe it’s a solvency one. A permanent solution has to involve an IMF program, with a clear and feasible framework for swift debt reduction. The issue of debt sustainability is also a legal one as under the Fund’s lending guidelines, large loans (or, in Fund jargon, “exceptional access”) can only be provided if IMF economists can offer explicit assurances to the Fund’s board that a country’s debt level is on a sustainable path. Felix Salmon notes that it's unclear how Europe would enforce on its own the reform-for-cash approach it is taking right now. What's needed is a credible bailout with an equally credible reform program in Greece.

Daniel Gros argues that the main challenge now is for Greece to undertake a very sizeable fiscal adjustment. Refinancing needs are about €30bn per year, but if Greece were to cut its deficit to 8% of GDP, its total financing needs add up to €50bn per year. Lower than market interest rates as promised by the EU/IMF aid package will not do the trick. A 5% would only save €900m per year, a tiny fraction of the Greek cash deficit. Even if the Germans would have accepted a 4% rate, Greece would only have saved €450m per year more.  The Greek problem is not one of liquidity but of insolvency. The key issue that will remain for years to come is whether Greece is willing to undertake the huge domestic effort required to achieve a sustainable fiscal position.

Barry Eichengreen writes that marrying salary cuts with product market deregulation can reduce the pain for Greek workers. Greece has the most overregulated product market of any OECD country.  State control of the economy is greater than anywhere else in Europe.  Greece has the most rigid and distorted national economy in the so-called advanced-country world. But this terrible starting point creates an opportunity.  Marrying salary cuts with product market deregulation can reduce the pain for Greek workers.  Their pay packets will be smaller, but with more efficient product markets they will buy more.  Product market deregulation will be difficult for previously-sheltered producers, but salary cuts will prevent the less efficient from immediately going out of business.  One can see here the beginnings of a “grand bargain.” 

Peter Boone and Simon Johnson argue that neither Greek nor Portuguese political leaders are prepared to make the needed cuts.  Europe will eventually grow tired of bailing out its weaker countries.  The Germans will probably pull that plug first.  The longer we wait to see fiscal probity established, at the European Central Bank and the European Union, and within each nation, the more debt will be built up, and the more dangerous the situation will get. When the plug is finally pulled, at least one nation will end up in a painful default.

Ryan Avent writes that total foreign-bank exposure to Greek, Portuguese, and Spanish debt is $1.2 trillion. Restructuring of all of that debt would be problematic, and potentially destabilising. But it's difficult to imagine German voters tolerating another round of Greek aid (which will almost certainly be needed) let alone big loan packages to Portugal and Spain. And the other issue is the matter of what happens with most of southern Europe attempts a major fiscal adjustment at once, cutting spending, raising taxes, and generally sucking demand out of economies that continue to contract. Things may work out in the end, but it's hard to see how.

Last, but not least, Felix Salmon points to a cool spreadsheet that allows you to look at potential scenarios facing Greece.

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