Over the centuries, Europe has witnessed many major battles that determined the continent’s future. There was the 8th century battle of Poitiers that stopped the invading Muslims and preserved Christian Europe. Waterloo finally put an end to Napoleon’s quest for European dominance. And of course, the landings at Normandy. Now Europe is facing a different sort of battle that will also have major consequences for the region’s future. As Europe’s leaders stumble towards a second bailout of Greece, the negotiations have in effect become a fight over who will pick up the tab – creditors or taxpayers. OK, well, it’s not quite as exciting as Napoleon vs Wellington. But a precedent may be set for how the euro zone will approach the escalating problem of European national solvency.
And if we needed any more evidence that some sort of resolution to the Greek debt crisis is of the utmost urgency, we’ve gotten more in recent days. Contagion has again stampeded through the euro zone. Italy, the zone’s third-largest economy, has even gotten dragged into the mess, threatening to take the 18-month old European debt crisis into a terrifying new direction. The sudden panic about Italy’s enormous pile of debt sent Italian government bond yields spiking – at one point breaking 6%, a euro-era record – and the Berlusconi administration frantically rushing an austerity plan through parliament. On Tuesday, Moody’s slashed Ireland’s credit rating to junk status and warned the country, like Greece, might require a second bailout, causing the yield on its 10-year bond to soar to a record as well, at more than 14%. The agency said the same when downgrading Portugal last week. Meanwhile, the problems in Greece remain unresolved. Poul Thomsen, the IMF’s mission chief to Greece, said Greece’s debt sustainability is on a “knife-edge.”
Much of the new contagion is being caused by the uncertainty surrounding the new bailout package for Greece. What’s really at stake in the negotiations is how the impending losses will be allocated. Originally, when Greece received its first bailout last year, the thinking in Europe was that almost all the pain would be inflicted on the Greeks themselves – through excruciating austerity measures that will deflate wages and smother growth – while the rest of the euro zone would probably suffer minimal or no damage. The Greek government approved an even more severe package of cuts and taxes in June to keep bailout funds rolling in. Meanwhile, Greece’s creditors were supposed to kept whole. The leaders of the euro zone hoped a “voluntary” rollover of Greek debt would ease some of the pressure on the government while avoiding a default.
In recent days, however, Europe’s approach to Greece has shifted. Policymakers are inching towards a decision to take more drastic action with Greece’s debt burden. Everyone with a calculator had determined long ago that Greece’s debt load – now at 160% of GDP — was unsustainable, but European leaders have only woken to that reality recently. Some sort of more comprehensive attack on the level of Greek debt is probably a good idea. A second bailout of Greece without some sort of debt relief seemed a plan doomed to fail. The only way out of the crisis is to alleviate Greece’s debt burden enough to allow the economy to recover more soundly. That would make it much more likely that Greece could pay off its remaining debts, rebuild investor confidence and return to international markets for funding. Simply bailing out Athens would probably keep Greece dependent on its neighbors to maintain its solvency.
But more drastic steps to deal with Greece’s debt will also mean someone loses money. There is just no way around it.
One proposal on the table (backed by Germany) is a bond exchange, in which private investors would swap their current holdings for bonds with longer maturities. That would take the heat off Greece by lengthening the time it has to pay back its creditors, but it is in effect a default, forcing creditors to take a haircut, since they would be getting paid on a longer time frame than they originally anticipated when buying the bond. A more far-reaching idea would probably be more effective, but it could also mean bigger losses. A proposal has surfaced to outright reduce Greece’s debt through a “buy back” scheme, in which the euro zone would have to shell out billions to purchase Greek bonds (probably through the existing $1 trillion bailout fund set up last year). That would eliminate a portion of Greece’s debt. A debt buy back would also force investors to swallow losses – bonds would be bought at a discount – and it raises the possibility that euro zone governments (in other words, taxpayers) would have to cover some of the costs of buying the bonds.
How this all plays out will depend on who wins out in the haggling to come. Politicians have a clear interest in minimizing any possible impact on their own national finances. Taxpayers vote, and in some of the richer euro zone members (Germany), they might not look kindly come election time on a government that uses their earnings to effectively pay off Greece’s debts. Sentiment in Finland has turned sour enough against European rescues that the country might have to be dragged kicking and screaming into any deal. The Finns have insisted that the Greeks put up collateral for any further bailout funds. (I’d wonder if Helsinki could foreclose on the Parthenon.)
But bankers have a clear incentive as well to limit their potential losses and push more of the costs onto the EU. Though some big banks in Germany and France seem willing to absorb some of the burden of a new Greek bailout, that doesn’t mean support will be widespread over a very diversified investor community. The recent turmoil in European sovereign bond markets is a big, fat, red warning flag from the investor community that unwanted haircuts on Greece will make them less enthusiastic about holding the debt of the other PIIGS, intensifying the debt crisis and making more bailouts more likely. The investor community is essentially blackmailing the euro zone – make us swallow losses and we’ll take our money elsewhere, leaving you to fund bailout after bailout. In other words, bankers would stick taxpayers with a bigger and bigger bill.
That may not sound fair but, from the bankers’ point of view, it makes perfect sense. My personal opinion is that creditors should take some financial responsibility. The whole notion that bankers should be absolved of the consequences of risk runs counter to the basic principles of capitalism and creates all sorts of moral hazard issues. Yet at the same time it is logical for investors to reduce exposure to potential risk, and in this case, that means running scared from the bonds of the PIIGS and spreading contagion. How can a fund manager justify taking further losses on European sovereign bonds after getting burned on Greece? In other words, further contagion might just be inevitable.
That means financial upheaval in the euro zone is likely to continue. The hope is that finalizing a second bailout for Greece would put a stop to further contagion by finally bringing some clarity to the process of resolving the crisis. But whatever Greek deal emerges won’t solve the debt problems of the other troubled PIIGS. It will also set a precedent for what might happen if the zone does have to tackle their problems in the future. In other words, how the zone’s leaders handle Greece’s debt will provide some guidance on what might happen if Ireland and Portugal require second bailouts, or how a Spanish rescue might proceed. The allocation of losses caused by Greece will provide a window onto potential future losses. And that, in the end, will determine investor sentiment towards the other PIIGS.
That’s why I’m getting increasingly pessimistic that the euro zone can actually solve the debt crisis. The process has deteriorated to the point where there might be no way back to normalcy. The problem from the start has been Europe’s hesitant approach to dealing with its debt problem. The notion that it was simply a liquidity crisis was always misguided – it is a crisis rooted in the very structure of the monetary union. Repairs to that union have been limited to setting new rules that might (but only might) make it function better in the future. Nothing has been done to fix the debt problem as it now exists. And no real changes in the euro zone have taken place to help the weaker economies recover and return to growth – such as wider euro zone reform to further deregulate and encourage the movement of investment and labor within the zone. Simply put, Europe has never addressed the real problems.
The euro was meant to be the ultimate symbol of European integration, a method of not only strengthening Europe’s economic competitiveness but also ensuring peace and democracy. Now the monetary union has descended into a tussle over who will get stuck with the bills for the euro’s failings. I wonder how long Europe’s leaders will keep paying up to keep the euro alive. Or will the currrency meet its Waterloo?