European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.
First the easy part: Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package.
Only the delusional can believe that, when everyone else is taking swingeing cuts, Greece's creditors can continue receiving 100 cents on the euro. It beggars belief that Greek government debt can top out at 150% of GDP, as the IMF envisages. At this point the government will be transferring well more than 10% of national income to the creditors. In a time of severe austerity, this outcome is unsustainable both economically and politically.
Another explanation is that negotiators thought it prudent to delay the inevitable restructuring until Europe’s financial markets and banks were in better shape. Well, now that financial conditions are deteriorating by the day, this argument no longer holds water.
A final explanation is that debt restructuring is complex, and neither the IMF nor the Greek government had worked out a plan. If true, this is the most damning explanation of all, for it means that the Fund went into negotiations unprepared.
Sooner or later, the creditors will have to exchange their existing bonds for new ones worth at most 50 cents on the euro. This will leave Greece with more public money for basic social services. That in turn will make it a tiny bit easier to achieve social consensus on the needed austerity measures. It will show the Greek in the street that he is not simply making sacrifices to pay the banks. All these are reasons for proceeding sooner rather than later.
Restructuring will not avert the inevitable recession
The Greek government is going to have to reduce its deficit by a further 4% of GDP in each of the next three years. With tax revenues falling, it is going to have to cut spending even more than that. With pensions and salaries being slashed, private spending will be falling as well. Greece will suffer a deep recession even if the government is able to cut interest payments. This is the hangover that follows the drunken binge.
So what can be done? Four things.
- First, the IMF and the European Commission can encourage Greece to reach a social consensus on restructuring and reform by showing that the creditors will also contribute.
They can facilitate the inevitable restructuring by using some of their bailout funds to provide credit enhancements, or guarantees, on the new bonds offered the creditors in the exchange.
- Second, Portugal and Spain must do more to convince the markets they are not Greece.
Both have smaller deficits and less government debt. But now that the markets have awoken to sovereign risk, Portugal and Spain need to do more to narrow their deficits. Unfortunately, Portugal has announced only increases in capital gains taxation, which is weak soup in an environment where capital gains are scarce. Spain has done even less. Meaningful spending cuts are in order if the Iberians want to avoid becoming two peas in the Greek pod.
The more fundamental problem in Portugal and Spain is structural, a problem that the two countries do, in fact, share with Greece. They need to reform their labour markets, fast. Keeping their debt burdens manageable will require economic growth. It will require exporting. And without labour market reform, growth will disappoint. The days are over when the Iberians can grow on the basis of English expats’ appetite for beachside apartments.
- Third, to give the Iberians time, the ECB will have to support their bond markets.
The ECB will have to buy their governments’ bonds directly on the secondary market. Doing so is the only way of preventing them from being further infected by the Greek crisis. With European growth now slowing, there is no reason to worry about the inflationary effects. If Portugal and Spain take meaningful fiscal and structural measures, they deserve the support.
From this point of view, the failure of the ECB to give a stronger statement of intent – and for Mr Trichet to say that the board didn’t even talk about bond buying in its 6 May meeting – is deeply worrying. The charitable interpretation is that the central bank is waiting to first see action from the Spanish and Portuguese governments, at which point it will jump in with both feet. The IMF says that it no longer attaches structural conditions to its financial assistance. Now we are in the bizarre world where the ECB does.
- Fourth and finally, the Germans need to support European growth by spending more.
Germans policy makers bemoan the country’s low domestic investment rate. An investment tax credit would address this problem. It would get Europe’s biggest economy growing faster. And faster growth in Europe will help everyone. The problem here is that German policy makers have their heads in the sand.
It’s not a pretty picture. The IMF botched its rescue. The ECB hesitates to erect the necessary ring-fence around Greece. Portuguese and Spanish policy makers underestimate the gravity of their position. German leaders are in denial. But although it may be too late for Greece, it is still not too late for Europe. That said, a solution will require everyone to wake up.