AGAINST THE ODDS, THE EURO WILL SCRAPE THROUGH / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Against the odds, the euro will scrape through

By Wolfgang Münchau

Published: June 19 2011 14:23


Last week taught us something important about the political economy of the eurozone.


There were two serious and overlapping crises. The first was a deteriorating dispute between Germany and the European Central Bank. It was about whether private investors should be forced to pay a contribution to the next loan programme for Greece. The dispute promised to derail the discussion for a follow-up loan, and could have forced Greece into a default. The second crisis was the near-collapse of the government of George Papandreou, Greek prime minister.


At the end of the week, Germany capitulated. And the Greek prime minister reshuffled his cabinet, ending up with with more reformers in it than before.


During the week, market commentators fell over themselves to predict the imminent default of Greece, and the inevitable break-up of the eurozone. They were wrong. Both may yet happen. Greek politics is unpredictable. And so may be the reaction of German parliamentarians. But it is not going to happen next week, or next month. And I am fairly sure that it is not going to happen over the next year either.


To keep Greece within the programme of the European Union and the International Monetary Fund, two things need to happen. Athens must comply with the conditions, and the conditions must be reasonable. The programme has been too reliant on austerity. It must, over time, shift towards reforms to be credible. Austerity alone cannot work.


Even if a sensible programme were implemented in full, I doubt the Greeks would be able to pay back their debt in full. But why would they want to default right now? The state ran a primary deficit of 3.2 per cent of gross domestic product in 2010. Since then, public finances have deteriorated. Daniel Gros, director of the Brussels-based Centre for European Policy Studies, estimates the net borrowing requirement, on a cash flow basis, went up from 5.8 per cent of GDP in the period from January to May 2010 to 9.3 per cent in the same period this year. Greece is still some distance from a primary balance.


A premature default would cut the country off from EU-IMF aid, from international capital markets, and possibly also from ECB lending. It would lead to an immediate collapse of the state. The government would not be able to pay salaries and pensions.


The present austerity programme is mild by comparison. If you were Greek, opposed to austerity and rational, you would not default now, but comply until you reached primary balance and then default. But that will not happen until next year at the earliest, possibly 2013.


Angela Merkel, German chancellor, also seems to have concluded that she does not want Greece to default. That public recognition weakens her negotiating position. But it, too, is rational. Germany would be a massive loser from a Greek default. And a collapse of the eurozone would cripple the German economy. The whole world would blame Ms Merkel. She would go down in history as the east German who sank the EU.


Her U-turn is therefore perfectly rational, but I still wonder why she allowed Wolfgang Schäuble to move so close to the brink last week. Until the middle of last week, the German finance minister was still digging in over the minimum conditions he wanted to attach to a private sector participation as a precondition for a new loan.


His spokesman insisted on a contribution that was “substantial, quantifiable, voluntary, and reliable”. He also explicitly rejected a Vienna-style initiative, which Ms Merkel now accepts as a blueprint for the forthcoming negotiations. This was a voluntary initiative in 2009 by EU banks to maintain credit flows to central and east Europe during that part of the financial crisis. The Greek problems are clearly of a different category. The best outcome would therefore be for the banks to agree to support and co-finance the Greek privatisation programme. But do not expect anything in terms of debt relief.


I expect that we are still on course for a second loan package, to be agreed either this week or in July. It would really be best if they could do this now to end the uncertainty that has led to an increase in the bond spreads, mostly importantly in Spain. Now that Ms Merkel has removed the biggest obstacle to an agreement, there is really no reason to delay the decision any further.


Unfortunately, the loan programme as discussed by the EU and the IMF is inadequate. For a start, the assumptions it makes about the scale of private sector participation are too optimistic. It is also irresponsible to set aside a sum for privatisation receipts in the financing package itself. It would be much more credible to use the receipts for debt reduction. I expect a third package to be necessary some time next year. Instead it would be better to agree a cast-iron package until 2014 that leaves no room for interpretation.


If Ms Merkel were really serious about ending the Greek crisis, as she promised on Friday, she would now have to capitulate on several more fronts. An announcement of partial debt forgiveness, a eurozone bond and a small fiscal union would end the crisis. We are not there yet. But the lesson of last week is that the political economy of the eurozone is driving us in that direction.

Copyright The Financial Times Limited 2011.