Several months of meetings and rushed aid packages have resulted in the following deal: investors will voluntarily take a 50 percent cut in the face value of their bonds in exchange for more security in their holdings, a higher return, and a shorter maturity. The European government’s “solution” to the Greek debt crisis is a band-aid and not a comprehensive treatment. This is as it should be. No major systemically altering deal should come out of an emergency meeting by Europe’s heads of state to find a workable fix to a single problem. However, this stopgap measure, while meaningful in some respects, could be far more effective if the EU countries stopped protecting their short-term interests and allowed for the European Central Bank (ECB) to support the European Financial Stability Facility (EFSF) by increasing the monetary base.
When the dust settles it is estimated that the adjusted bonds will have a 21 percent reduction in net present value and Greece’s banks, which will be taking a 25 billion Euro loss, will be given 30 billion Euros as collateral to insure their solvency. This plan is expected eventually to cut Greece’s debt to 122 percent of GDP. Additionally, to insure that the Italian and Spanish banks do not become insolvent from another bank run, the European Financial Stability Facility is supposed to increase its reserves to 1 trillion Euros. The finalization of this proposal buoyed U.S., European, and Asian markets: shortly afterwards, the Dow Jones Industrial Average jumped 4.91 percent, the DAX 100 3.01 percent, and the Nikkei 1.8 percent.
The world market’s positive response to the Euro-zone’s solution does not mean, however, that European finances are any more secure. Whereas this proposal is a first step in the right direction, the deal does not completely solve the short run problem of Greece’s finances or prevent the spread of the debt crisis. Even with its debt cut by about a fifth, Greece will have a great deal of trouble paying back a sum larger than its GDP. The government has an extraordinarily poor tax collection system and thus no reliable source of revenue other than debt sales. Because the Euro allowed Greece to borrow more at lower interest rates, the parties in power promised their voters benefits that could only be sustained by selling this debt. But now that this gilded age has passed, Greece has to either collect taxes or cut benefits.
Yet, any Greek government that pushes austerity too far would be effectively committing political suicide and dooming their country to a longer and more severe recession. A report by the European Central Bank showed Greece’s output this year will shrink by 5.5 percent, and it has been postulated that the nation will not return to growth until 2013. It will be extremely difficult for Greece to raise its revenue to the point where it can pay off even this fraction of its accrued debt, as doing so would further shrink its economy. This reality will inevitably lead to future problems regarding Greece’s finances.
Because a Greek default is a systemic risk to the Euro, economic powerhouses like Germany and France will continue to give Greece the deal of a lifetime. Greece, in turn, will continue to waffle and bargain on these agreements because it does not want to commit to austerity. At the end of the day, Europe will support Greece’s 450 billion dollar debt, because the alternative is to suffer the massive deleveraging that would result from Greece’s failure to pay. However, because it is politically unsavory to just bail Greece out, the larger countries will tiptoe around the issue and try and find other, less efficient, ways for Greece to “pay its own way.”
The second part of this deal is supposed to provide the EFSF with enough firepower to prevent larger economies like Spain and Italy from becoming insolvent. Because nations in the EU have already expanded the newly formed authority several times over, however, this new expansion is one that will not take the form of money. The EFSF will be given two new tools: the first allows the EFSF to insure the first losses of any new bonds within the Euro-zone (essentially, any non-catastrophic loss on a newly issued bond, give or take 20%, is now insured by the EFSF); and the second mandate allows the EFSF to create a series of special purpose vehicles financed by other investors and designated to specific counties to prevent the risk from spreading.
Yet, these new tools may give the EFSF less leverage than expected. Insurance does not work and is not comforting if every investor knows the institution backing the insured bond cannot reimburse the holder. Additionally, if Germany is not willing to place money in these special purpose vehicles why should Japan or the China, who have no immediate stake in the Euro-zone? The likely answer is that they will not. Thus, both the preventative measures and the stopgaps for the Euro-zone and Greek debt clearly have major flaws in their designs.
There was one option that could have lessened the cumulative sting of Greece’s new debts and secured the Italian and Spanish economies. But it was tabled because it would have negatively impacted creditor nations. Specifically Germany could have given the European Central Bank the ability to print a large number of Euros to support the EFSF. This option is completely within set of powers of the ECB, but the ECB’s ability to use those powers is limited by the nations of the Euro zone. The ECB states that its mandate is to “maintain price stability with inflation rates of below, but close to, 2% over the medium term.”
If the ECB were to scrap its mandate for a short period of time and inflate the Euro, the rest of the stopgap measure could work. Inflating the Euro coupled with the haircut would be especially painful for German banks, which hold large amounts of other European debt as well as Greek debt, but it would not force them to deleverage nor would ECB-led inflation fundamentally change the structure of the Euro zone. A moderate increase in the inflation rate would slightly lessen the real value of the debt held by the countries of the Euro-Zone and give the EFSF the firepower necessary to back up its new mandate to insure the potential first losses of new debt issued by countries of the Euro-zone.
Along with the already accepted measures, inflating the Euro is a quick and easy answer to the short-term problem of putting the Euro-zone on surer footing and making sure Greece can repay the remainder of its debt. The Germans have to realize that this may be the Euro-zone’s only way to insure that this deal does not become a meaningless one. While the German creditor banks may suffer some penalty from this policy of inflation, these losses will be miniscule compared with the financial meltdown that would occur if Italy defaults on its debt or the Greek deal has to be reworked. Both of these scenarios are not that far-fetched if the Euro-zone cannot insure that this deal is supported with something more tangible than the current proposal.
Still, the new deal is just a nicely dressed stopgap measure designed to do the bare minimum, make everyone happy, and avoid any major changes. Such a deal would be fine if the stopgaps could effectively insure Greek debt against further default and prevent the crisis from making Italian debt insoluble. Without the support of additional currency, however, the stopgap measures fail to do either. Germany is going to fight an inflation policy because such a policy would reduce its banks’ returns. Consequently, German interests have placed the rest of Europe at risk of a prolonged crisis that could be greatly helped with just a moderate amount of inflation.
In the long run, the Euro-zone will have to change its structure or face an endless cycle of smaller countries abusing their position with the larger. But for the short term, as long as the mentality of trying to “have everyone keep their cake and eat it too” prevails among the leaders Europe, no stopgap measure will ever give the Euro-zone economies the breathing space they need to introduce major reforms.
