EUROPEAN FARCE DESCENDS INTO GREEK TRAGEDY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

European farce descends into Greek tragedy

By Wolfgang Münchau

Published: December 13 2009 18:27

I almost fell off my chair when I heard Angela Merkel say that the European Union might sometimes have to take charge of the fiscal policies of highly indebted members. Does this mean that the German chancellor is abandoning her attachment to a rules-based system of fiscal policy co-ordination? Probably not quite. If I interpret her brief statement correctly, she is only talking about times of crisis. Nevertheless, this is probably the most far-reaching economic governance proposal I have heard coming out of Germany.

Her proposal was triggered by the Greek crisis, which has brutally exposed the weaknesses of Europe stability and growth pact. There is still a chance that catastrophe can be averted, if George Papandreou, Greece’s prime minister, announces a robust deficit-cutting plan today. Experience teaches us to be cautious. But if the plan is judged insufficient, this crisis might get out of hand.

The European response is at least in part to blame for this disaster-in-the-making. In November, European finance ministers came up with what they thought would be a clever plan – too clever by half as it turned out. The idea was to bounce Greece into Irish-style austerity – a credible medium-term deficit reduction plan. To underline the urgency of the request, a string of finance ministers and central bankers went on the record with their concerns. Axel Weber, president of the Bundesbank, warned that Greek bonds might not be eligible as central bank collateral forever. Jean-Claude Juncker, president of the eurogroup of eurozone finance ministers, spoke almost daily, one day expressing outrage at Greek malpractices, another day explicitly ruling out default.

Even Fredrik Reinfeldt, the prime minister of non-eurozone Sweden, felt the need to comment. The Greek situation, he said, was “of course problematic, but it is basically a domestic problem that has to be addressed by domestic decisions.” His comment reminded me of the now infamous statement by Peer Steinbrück, Germany’s former finance minister, when he confidently declared, shortly after the Lehman collapse, that the subprime crisis was primarily an American concern.

All of this not only failed to solve the problem; it made it worse. Instead of preventing a crisis, European policymakers, obsessed with internal procedural rules and oblivious to global financial markets, almost triggered one. Last week alone, two-year bond spreads between Greece and Germany rose by 1.3 percentage points. The EU’s politicians have confused global investors by appearing to link the unconditional bail-out guarantee, given by Mr Steinbrück in February, to Greece’s compliance with the stability pact. Ms Merkel herself reproduced a weaker version of that guarantee on Thursday, but the conditionality is still not clear.

It is no accident that rating agencies took a hard look at Greek and Spanish debt at exactly the moment when the EU’s policy stance was at its most cacophonous. If the guarantee had been 100 per cent credible, there would be no justification for even a small spread between Greek and German bonds. The markets’ perception of the credibility of this guarantee is absolutely critical.

By placing blame on European officials, I am not condoning the way successive Greek governments have behaved. There is no question that the country’s political leadership acted in bad faith, that it misrepresented statistics and that it has made insufficient efforts to stick to the rules. But to provoke a financial crisis is not a constructive way of dealing with this problem.

Most of all, it is bad for the EU. If it ever came to a high-noon showdown between the Greeks and the EU, I would bet on the EU blinking first. We are headed towards a situation in which the risk of financial distress and contagion leads to an unconditional bail-out, whether or not Greece is reforming sufficiently.

The reasons we are at this juncture lie in the nature of the stability and growth pact. It is a fair-weather construction, ill-suited to crisis. It collapsed before, in the previous recession. Reformed in 2005, the pact has become more flexible. But once the financial crisis came, it lost all traction. The problem is not, as is often reported, that countries run budget deficits of more than 3 per cent of gross domestic product. This is perfectly alright during a crisis, even under the existing pact. The problem is the evident failure to co-ordinate binding exit strategies among the member states. The pact is about procedure, and Greece has not been following the procedure in good faith. Nor, in fact, have other member states, including France.

Hence Ms Merkel’s idea of a separate crisis management regime. If she is serious about her proposal, she will have to accept that other dimensions of crisis management might need to be included – common financial resolution policies, more effective EU-level bank supervision, fiscal stimulus and structural policies. But there can be no doubt that the eurozone needs a crisis-management regime capable of coping with rough macroeconomic conditions of the kind we face today.

Copyright The Financial Times Limited 2009.