Eurozone Rescue Going Off the Rails

In the runup to the crisis, it was striking to read the undertone of worry in quite a few of the articles in the Financial Times, and I don’t mean only Gillian Tett’s fixation on collateralized debt obligations. It was palpable that a lot of writers were uncomfortable with how frothy the markets were, yet couldn’t say anything too much at odds with what their largely cheerleading sources were telling them.

Even though the overall mood at this juncture is far more downbeat, there is again a reporting gap between the pink paper and the two major US print business outlets, the Wall Street Journal and the New York Times on the expected crisis nexus, the Eurozone. Both US media outlets have a prominent article on the latest Euro exercise in rescue brinksmanship. And they are almost the same story; indeed, at this hour, they perversely use identical photos of Merkel and Sarkozy conferring. They present the formerly aligned core nation leaders as being at odds, then widen the frame to explain the divisive issues. First,, the Germans want a deeper but voluntary haircut of at most 50% of Greek debt; the French do not want to go beyond the 21% reduction structured last July. The steeper writeoff would, of course, lead to a bigger hit to French banks. Second France (effectively) wants the ECB to provide further leverage to the EFSF directly, while Germany and the ECB itself are decidedly opposed (Germany wants individual states to be responsible for their banks, with the ECB acting as a guarantor). The Journal was thinner on details and focused on the hardening political stances, not just between France and Germany, but other states as well. Per the Journal:

People familiar with the negotiations said Germany and France remain so far apart on key issues that Ms. Merkel couldn’t get a green light to sign a deal from her increasingly assertive parliamentarians.

If you rated these articles as sobering, the far more detailed coverage at the Financial Times has an undertone of despair. And one story emphasizes an issue absent from the times and mentioned only in passing in the Journal: the experiment in Greece in radical austerity is killing the patient. From the Financial Times:

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.

The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago.

Under a more severe test run by economists for the so-called “troika” of lenders – the IMF, European Central Bank and European Commission – Greece’s bail-out needs could balloon to €444bn, the study said.

Now before you attribute this shortfall to civil disobedience, which has been a contributor, an even bigger factor seems to be a major breakdown of a wide range of critical operations, such as power and garbage collection. And the bailout plan had some absurd assumptions, such as forecasting proceeds from infrastructure sales that were three times the level private sources expected them to fetch.

A must-read set of on-the-ground accounts in the Guardian (hat tip reader FlyingKiwi) gives a sense of how bad things are:

The poor and middle classes are being asked to pick up the bill for the excesses of the rich and corrupt; those who have declared their taxes correctly continue to be taxed more than those who don’t; and in a country with one of the highest cost of living, wages are being cut and taxes being raised….

I live in chaos. Chaos is a Greek word and aptly describes life in this country. I have been a good citizen of this country and have worked hard in the 25 years that I have lived here. I work from 2pm to 10pm daily. I put in 40 teaching hours per week. If you add the lesson planning and marking it’s nearly 50 hours per week. I only see my husband for half an hour a day as he teaches in a state school in the morning but because his salary is so low he needs to supplement his income in the evenings. How many of our European colleagues work so many hours?…

I can’t get to work easily most days because public transport is usually on strike three days every week. The streets are piled high with rubbish…

I work with a local council in Crete. There is an increasing sense of the country having fallen apart. All temporary contracts have been arbitrarily cancelled so we can’t run any sports or arts programmes, even those which are profit-making. No one answers the phones in the central offices in Athens because of the sit-ins, so we can’t work our way round the red tape.

The town hall itself has been occupied by strikers for the last week. The rubbish hasn’t been collected for three weeks. Standard processes are paralysed. This includes the payment of staff – many are owed over six months.

Now remember the earlier prevailing assumptions. Even though Greece was widely understood last year to be deeply underwater and independent observers all said a bond writedowns of at least 50% were in order, it was also assumed that Greece alone was a manageable problem. The danger was seen as contagion to bigger economies, particularly Spain and Italy.

But Greece alone is morphing into a potentially unsolvable problem. The EFSF, with its CDO-like structure and its not-very-convincing of states guaranteeing the very same fund they are borrowing from, was always better on paper than it would work in reality. Given the difficulties of getting approvals even for existing plans that are in desperate need of reworking, the only way out of the box would seem to be to resort to the ECB (as in “print”). But Germany remains firmly opposed, and the ECB is not too keen.

The FT highlights a second issue: given the difficult of getting any fix approved, and that Italian bond spreads are elevated, it seems crucial to get a big enough fix approved. But given the impasse over Greek haircuts, the belated willingness to consider a much larger bailout fund is exposing its widely discussed design flaws (this blog was far from alone in pointing them out). Again, the FT:

The fight between Germany and France over how to increase the firepower of the eurozone’s €440bn ($609bn) rescue fund comes down to a fundamental question: is there enough money in Europe to prevent a run on the €1,900bn Italian bond market?…

The rescue fund, formally called the European financial stability facility, is only able to raise cheap money for bail-outs because it relies on the fiscal reputation of its two biggest members, France and Germany. They are two of only six nations in the 17 country eurozone that have a triple A debt rating.

But as the crisis in the eurozone has grown, spreading from small peripheral countries to major economies such as Spain and Italy, the sheer size of countries’ debts that need to be supported by the EFSF has threatened to buckle the hastily constructed edifice – and the weak point is in Paris.

Adding new money to the fund has proved impossible because it would probably force a downgrade of French debt, making the entire EFSF rescue system collapse. Plans to increase the fund’s firepower have similarly run into trouble because the leading “insurance” scheme – which would use the EFSF to guarantee losses on Italian bonds – saddles France with too many liabilities.

There are other possible ways out of this seeming impasse, such as having the IMF assist in rescues in Spain and Italy. The Eurocrats have managed in the past to cobble deals together at the 11th hour, even if they satisfy the markets for only a few days. But every time, the issues that need to be solved are more daunting, and the various government leaders believe or pretend they have less bargaining room than they did in the past. While it would be better if I were proven wrong, there is not much cause for optimism here.

This post originally appeared at naked capitalism and is reproduced with permission.

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Håvard Halland Håvard Halland

PHåvard Halland is a natural resource economist at the World Bank, where he leads research and policy agendas in the fields of resource-backed infrastructure finance, sovereign wealth fund policy, extractive industries revenue management, and public financial management for the extractive industries sector. Prior to joining the World Bank, he was a delegate and program manager for the International Committee of the Red Cross (ICRC) in the Democratic Republic of the Congo and Colombia. He earned a PhD in economics from the University of Cambridge.