What’s at stake: Despite a successful placement of a 5 year bond by the government of Greece earlier last week, Greek debt continues to sell off sharply suggesting no credibility and confidence in the Greek Fiscal plans. Rumours of a failing placement of a large chunk of Greek debt to China’s State Administration of Foreign Exchange (SAFE) has sent a shock wave that increases sharply the probability of some kind of support mechanism to be devised by the EU. The European Commission will release its report on Greece’s Growth and Stability Fiscal Plan on Wednesday which is likely to remain fairly critical given the extent to which one offs measure contribute to the adjustment. Although European and Greek leaders have continued to dispel the need for a bail out, reports suggest that European policymakers are actively thinking about a plan to salvage Greece that minimises moral hazard and maximises the scope of any fiscal adjustment. The informal European Summit of Heads of States and Government in Brussels on February 11th should be critical to get leaders to agree on something while the ECOFIN of February 16th is certainly the moment of truth.
Is there a plan B?
The Economist’s Charlemagne argued on Thursday that the bail out has become certain and that the question has now to do with how European Union governments will put it together. But statements by EU policymakers over the week end tried to signal that there is no plan B and that only fiscal adjustment is on the cards. According to a draft proposal the European Commission will recommend on Wednesday that the Greek government cuts average nominal wages in public institutions.
Edward Hugh argues that these statements need to be interpreted carefully as the whole argument depends on what you consider a bailout to be. If you take the view that a bailout involves a restructuring of Greek Sovereign Debt, with the EU itself offering to pay a part, then this is clearly not on the cards, at least at this point. But if you consider the “bailout” to be simply a loan, which in some way shape or form would be guaranteed by the EU institutionally, then it is hard to see how this would not happen. Officials are trying to talk down the market pressure in the hope that the spread on Greek bonds will decrease to a point where there is no need for anyone else to make a loan. Such a scenario seems highly unlikely now.
Would it be legal under EU laws?
We reviewed in the past the legal debate about the possibility of a bail out (see here in particular) which continues to rage although the consensus is still that most legal obstacles standing on the way to a bail out can be circumvented in a way or another.
Tony Barber argues that the EU possesses the legal power to rescue Greece as laid down in the Lisbon Treaty by making recourse to the “exceptional occurrence beyond its control” clause as described in Article 122. Three conditions need to be met for this clause to apply: 1) a recommendation to that effect by the European Commission; 2) proofs of exceptional occurrences beyond the control of the country – the question here is whether a financial crisis can be considered as such (see here for an analysis of this point by a German Law Professor) ; and 3) a qualified majority vote by the Council. Edward Hugh writes that this clause only applies to balance of payments crisis (used for Hungary, Romania, and Latvia) which cannot describe the Greek situation as it stands. Pietter Cleppe from Open Europe suggests that the no bail out clause as laid out in Article 103 (formerly 100) is legally superior. The written answer by the Council to the Irish MEP Kathy Sinnot in May 2009 makes it explicit, demanding that any action taken under the exceptional occurrence clause under article 122 remains fully compliant with the no bail out clause as laid out in article 103.
What are the possible options?
Beyond legality, implementation poses a number of questions as fighting moral hazard remains a central concern. A few options have been discussed so far ranging from bilateral support, EU support, and support by other European institutions (European Investment Bank), quasi-public institutions (Caisses Des Depots, LandesBank) and the IMF.
Despite repeated claims by the IMF (see Marek Belka, IMF’s European Chief, Dominique Strauss Kahn or John Lipsky) that it was ready and willing to assist, the FT reports that European governments have very strong reservations about going for the IMF route. Models and Agents argue that it is unfortunate as the European Commission/Council have a truly hopeless track record of enforcing fiscal consolidation or structural reforms on eurozone members. This means that whatever plan is laid out for Greece, it could lack the credibility to pass the “rating agencies’ test”, let alone the “markets’ test”. To the extent that the Europeans prove, once again, incapable of enforcing fiscal and structural reforms, implementation slippages by Greece would set a dangerous precedent for other eurozone members to follow.
Sebastian Dullien and Daniela Schwarzer argues that the EU should set-out conditionality under which countries would get rescue packages which would involve national budget of the ‘bailed’ to be approved by the EU and its member states, for instance by the ECOFIN or the Eurogroup. This would mean a clear limitation of fiscal sovereignty which would most probably require a new Treaty but such a device would be incredibly more potent that the Growth and Stability Pact and would increase the leverage of the ‘bailer’ while limiting contagion.
Joseph Stiglitz suggests using EU institutions such as the European Investment Bank which could even undertake countercyclical investments to offset deflationary impacts of the budget cuts. He also calls on the EU to reframe its budget targets and use primary deficits (net of interest payments) rather than structural deficits just as the IMF did – recognizing that volatile financial markets mean that interest payments are not really within a country's control.
The idea of bilateral credits or guarantees has been suggested by several press articles (Le Monde and FT Deutschland) but most European leaders that have commented on the issue seem to give precedence to the use of EU institutions. Others have suggested that EU cohesion funds could be disbursed quicker to support Greece’s public finance. But the total allocation of EU territorial, convergence and cohesion initiatives would only total EUR 18.2bn between 2007 and 2013 while they amounted to EUR 24.7bn for the 2000-2006 period.
There is also a monetary question and a potential role to be played by the ECB. Since October however, the ECB has voiced rather clearly its departure from “constructive ambiguity” to a language and a set of actions that are a lot clearer. Recent comments by Trichet, Stark or Weber have, if anything, added to the notion that the ECB wanted to get out of the implicit support role delivered through massive liquidity operations which involved larger than normal credit risk. Discussions surrounding the end of full allotment to the ECB’s refinancing operations, the maturing 1 year LTRO in June 2010 and the return to a stricter definition of eligible securities at the refinancing operations are all making the untold support of the ECB less likely.
Although, the wildest fears of EMU break up are dissipating, Charles Goodhart and Dimitrios Tsomocos are proposing a monetary solution based on the introduction of IOUs in Greece, a quasi parallel currency through which all domestic transactions, minus taxes are paid. A similar solution was used in California recently or Argentine provinces before 2000. Essentially the government passes a decree that states that such IOUs would be acceptable for all internal payments, except tax payments, between residents, but not for any external payments. All external monetary relationships, including interest payments, remain unchanged. Internally all price/wage relativities, tax rates, etc, remain unchanged. What changes is the relativity between internal and external payments. Domestic wages and costs fall relative to their prior level; tax rates remain the same, but the enhanced activity raises revenue, and there is a reduction, as measured in euros, in interest paid to domestic residents. It would be messy, and an unattractive dual currency mechanism but it could work. It would protect the European banking system, safeguard the basic existence of the euro, and, for the eurozone countries in danger of default, it might be the least bad option.
Spill over risks
Last but not least, the central question is that of contagion and spill over risks. Paul De Grauwe argued in December that the Greek demise could be the start of systemic crisis of the eurozone, which he expects would compel EU government to support Greece. But contagion hasn’t been that straight forward; indeed, Daniel Gros argues that beyond the rather static metrics of debt to GDP or fiscal deficit, the real risk for contagion lies with the reliance on the need for external financing – i.e. the lack of private sector savings. In that sense, Italy, Spain or even Ireland increasing private sector savings helps to stabilize the situation. Wolfgang Münchau does not agree and believes that Spain is likely to squander that advantage. While the Greek government is at least beginning to recognise the need for reform, Spain’s political establishment remains in denial.
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