The members of the eurozone and the EU have apparently decided that they must heroically rescue Greece, that this is better than having the IMF do it. Senior figures in Brussels feel that the latter alternative is unthinkable. I am a little confused about why. Martin Wolf writes in the Financial Times this week that to bring in the Fund “would demonstrate that this is not a true union at all.” But the EU and EMU and not true fiscal unions. If the citizens of Germany and other more successful countries were willing to bail out the Greeks, then fine; the EMU would be ready to be a fiscal union. But they are not; so it is not. Given that reality, what is wrong with something that “demonstrates” it?
The Maastricht treaty and the Stability and Growth Pact placed fiscal constraints front and center on the list of requirements constituting the Golden Fleece that a country must achieve in order to qualify for euro membership. Why? The same reason that the European Union has an explicit “no bailout” clause. Precisely to avoid the classic situation that seems to be facing German taxpayers today. What has changed since the euro’s birth? Only one development, which was predicted by many an oracle: the realization that huffing and puffing from Brussels and Frankfurt are wholly inadequate to prevent members large and small from breaching the 3% deficit rule. (No Cerberus there. Enforcement was always to be the Achilles heel of the SGP.) Greece leads the pack, with a budget deficit last year of 12.7% of GDP, even assuming we can now believe its accounting. See Chart 1, below. The fears of German taxpayers, that the euro was a Trojan Horse, are more well-grounded today than they were at Maastricht, not less. European leaders should not continue to ignore the widening democratic deficit. (And disguising these transfers as loan guarantees would only be a futile effort to perpetuate the obfuscation. Once the crowd begins to realize that the Emperor has no clothes, his dignity is not enhanced by continued denials.)
I am not even sure why it is considered anathema to run up default risk a little more. It would help force Dionysian citizens of Greece to see the need for painful reform in their country. If a presumption is now established that default risk is to be suppressed, moral hazard will wipe out all pressure on future eurozone governments to keep their finances in order. Indeed, some of us were puzzled why, for most of the years since 1999, the financial markets had failed to distinguish among euro members by creditworthiness: until recently the interest rate spreads of the Mediterranean countries over the German bond rate had been close to zero. Applying the same interest rates to all countries regardless of merit was Procrustean. That this began to change in late 2008 was therefore not necessarily a bad thing. Then, in 2009, the sovereign spreads in Ireland and Greece shot up, reflecting investors’ divergent perceptions of these countries’ debt problems. This put pressure on them to adjust. The Irish responded by undertaking more draconian fiscal retrenchment than Greece. Partly as a result, Irish government bond rates have declined over the last year and are substantially below Greek rates, which have now risen almost to 400 basis points. (Chart 2, below.) Is Athens now to be rewarded by intervention from Olympus?
Things are not yet bad enough to require a Greek default. Quite likely, by now, they are bad enough to require outside intervention. But shouldn’t Greece have to draw on the IMF first, rather than drawing on Germany and France? The IMF could impose conditionality, thereby helping the current government with the Sisyphean task of making the necessary cuts stick. No doubt the government in Athens will promise Frankfurt or Brussels, as conditions for a loan, that it will clean up the Augean stables of its pension system, tax evasion, and the rest of its finances. But there is no use in pretending that such promises could be enforced in the future. Enforcement is not credible, given the politics and given what has come before. But conditionality is what the Fund does for a living. For all the criticism it sustains, the IMF is a better mechanism for tying Odysseus to the masthead than is any other institution.
Europeans worry that if Greece were put into default, troubles in Portugal and Spain would appear as quickly as heads on a hydra. Perhaps it is glib for an American, on the other side of the Atlantic, to discount the financial strains that Greece is placing on Europe — including Mediterranean contagion, loss of prestige of European institutions, and depreciation of the euro. But in fact it is the northern Europeans who should be most eager for the IMF to come in. They should be the most worried about what they are going to say to Portugal, Spain, Italy and Ireland — not to mention the Eastern Europeans, if instead they have just bailed out Greece.
The risk of default is the sword of Damocles hanging over all debtors. It is often good policy when bailing out debtors to let at least one fail, preferably the one most deserving of this fate, thereby preserving a foothold in the long-term fight against moral hazard. Charles Wyplosz has made this point with reference to Greece, and cited the decision to let Lehman Brothers fail in September 2008 as a precedent. I would add as another precedent the decision to let Russia default in August 1998, at a time when the markets presumed it would be always be bailed out no matter how bad its compliance with fiscal promises. In both episodes the short-term global effects of the failures were severe; but in both cases the alternative was establishing a precedent of blanket bailouts. The guideline that one debtor should be allowed to fail may sound cavalier and arbitrary. But better to steer such a middle course, than either to let everyone fail (the Scylla that is supposedly preferred by the noisy moral hazard police on the right), or to let nobody fail (the Charybdis preferred by also-noisy social workers on the left). Even if it proves necessary for the northern Europeans to rescue the next-worst debtors in line, after a tragic outcome in Greece, I don’t see that they are better off by starting now with Greece.
Source: The Economist, Feb. 4, 2010
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