SOME USEFUL STEPS BUT NOT MUCH OF A STRATEGY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Some useful steps but not much of a strategy

Wolfgang Münchau

July 21, 2011

It looks like there will be deal on a eurozone package for Greece. The full details are still missing, but it appears that the eurozone is forcing Greece into a selective default. As part of such a package, short-term Greek debt will be more or less forcibly converted into long-term debt. The wretched bank tax is mercifully off the table. And the European financial stability facility will most likely be allowed to purchase Greek debt at a discount. Let us not mince words here. This would be a default, the first by a western industrialised country in a generation. I am not quite sure how it is possible for the European Central Bank to agree to this, or to all of this. But I will surely be intrigued to hear how Jean-Claude Trichet will manage to be consistent with what he said a few days ago. There are also reports that the eurozone leaders may accept a more flexible EFSF beyond those bond purchases.


So would this be a good deal? Those who are in the thick of it are running the danger that they got so obsessed with the formidable technical complexities that they lose sight of the bigger picture. The problem of the eurozone is not Greece, or some other small country on its periphery. The existential danger is the rise in market interest rates of Italy and Spain, two large countries in the eurozone’s core. To state the goal of today’s meeting in simple terms would be to say: the survival of the eurozone depends on whether its leaders will be able to take decisions that would allow Italy and Spain, and everybody else as well, to remain inside the eurozone on a sustainable basis. Greece is now just a side-show.


If that is the goal, I would judge today’s outcome in terms two priorities. The first, and most important, is the size and flexibility of the European financial stability facility, the rescue umbrella. At present, the overall size of the EFSF is €450bn. With a second Greek credit about to be agreed and second programmes for Ireland and Portugal very likely, the ceiling will not be big enough to bring in Spain, let alone Italy. To do that that the ceiling would have to be doubled, or trebled. Without this increase, it is inconceivable that the eurozone can get through this crisis intact. One could think of other constructions, such as having no fixed limits at all or sliding limits. The structure of the EFSF would have to be changed if it was going to be made this big. It would have to be properly capitalised. Italy’s 18 per cent share in the EFSF would otherwise not be credible.


This will not be agreed today and this alone is why the summit will fall short of what is required. As it stands, the eurozone has a mechanism that can deal with Greece, Ireland and Portugal, but no other country.


Size and flexibility go together. At present the EFSF can only lend money to governments. In turn, the applicant countries are subject to a full European Union/International Monetary Fund supervised austerity programme. You are either in or out. It is important that the EFSF can act pre-emptively, even in respect of countries that are not part of an official programme. The EFSF should also be able to purchase bonds on primary and secondary markets, help refinance banks or give emergency credits during a crisis. It cannot do any of these things now. The bigger and the more flexible the EFSF becomes, the greater the chance that Italy and Spain can get through the crisis.


Second, of course, would be a plausible programme for Greece. The construction currently discussed has some merits, but I am still not sure to which extent it will help Greece. If one accepts the logic of an involuntary private-sector participation, and the advent of a selective default rating, then one should better make sure that one ends up in a situation where Greece defaults, and yet is still not in a position to repay its debt in the long run.


What’s the point of default in such a scenario? If the final construction leads to a reduction in the Greek debt from an estimate year-end level of 175 per cent of gross domestic product to 130 per cent after a default – with no changes to its real exchange rate – it is not clear at all how Greece can be solvent at such a still high level of debt.


The outlines of the agreement, as they have been presented so far, still fall short of the main goals – to have an EFSF capable of dealing with Italy and Spain – and to have a Greek package that reasserts debt sustainability one way or the other. Like all decisions in the European Council, this is a compromise for sure. But there are limits to compromises when you are dealing with a contagious debt crisis. You either do enough, or you do not. They are still lacking a strategy to deal with the wider crisis.


The writer is an associate editor of the Financial Times and president of Eurointelligence ASBL