Buying Time, Building Firewalls
The latest deal on Greece is a reminder that European politicians have finally got a better grip on the many challenges facing the euro zone. After saving Greece from collapse once again, they will now spend the next several months preparing for a likely Greek default. The next step will be to increase the combined firepower of the so-called firewalls − the European Stability Mechanism (ESM) and the International Monetary Fund (IMF). In the corridors of European political power, market driven panic has been replaced by a much more methodical approach to the crisis.
Of course, the meeting of Europe’s finance ministers on Monday of this week bore all the familiar traits of past gatherings: exhausting talks lasting well beyond bedtime, tales of dramatic brinkmanship, the ghost of a euro collapse hovering over Brussels, and pale-faced ministers emerging early in the morning to announce the latest deal to save the common currency. However, the fundamental decision to bail out Greece had already been taken. German Chancellor Angela Merkel has no intention of allowing a disorderly default of Greece, at least for now. And so, instead of delivering the usual hastily concocted plan, rich in rhetoric and poor in detail, Europe’s leaders submitted a more detailed, carefully constructed package. To underscore how significant he thought the latest deal was, U.S. President Barack Obama rushed to pick up the phone just hours after the end of the meeting to congratulate the German Chancellor Angela Merkel on the agreement.
Overall, there is palpable relief, both in Washington and in European capitals, that by avoiding a Greek default, Europe has chosen to postpone its “Lehman moment.” But how long can this dance around the edges of the Greek volcano continue? Finding a positive answer requires a good dose of faith. In fact, most economists who have studied the numbers have lost hope. Most don’t see how, with an economy in free fall and upcoming elections, Greece could possibly comply with the strict conditions laid out in the bailout package and reduce its debt to GDP ratio to around 120% by 2020. Some predict that Greece could face new trouble as early as this summer. For others, the country could face default and possibly an exit from the euro zone by year’s end. Former German Finance Minister Peer Steinbrueck says that his government needs a plan B, just in case.
Looking beyond Greece, many have deep concerns about the viability of the reform programs now under way in much more relevant peripheral countries, such as Spain and Italy. Structural reforms are welcome, but in the near term they will probably worsen the recession and could trigger a new cascade of destabilizing consequences. Southern Europe is also experiencing a widespread tightening of credit conditions. According to the Banca d’Italia, the Italian central bank, access to loans, particularly for those small and medium sized companies that could and should create new jobs, deteriorated considerably in December of last year. Many banks deny the charge, but it is still unclear how willing they are to pass on the cheap money they are getting from the European Central Bank (ECB) to the real economy. With its so-called longer term refinancing operation (LTRO) the ECB has flooded banks with liquidity, as well as prevented the collapse of more than one bank. But if financial institutions hoard the cheap money they are getting from the ECB, or merely use it to engage in limited carry trades with sovereign bonds, the real economy does not benefit. This is a challenge ECB president Mario Draghi is well aware of. For now, Draghi is calling for time and patience, and reminds skeptics that it too soon to determine the effects of the ECB’s lending program on the real economy.
Time and patience are ultimately what the latest Greek rescue package is all about. It buys time and prepares the ground for the implementation of the next part of the plan — inoculating the euro zone against the Greek virus.
Spain and Italy are not yet immune. Both countries are refinancing a mountain of debt, a task that should be completed by about the end of April. Until then, Madrid and Rome cannot afford renewed market turbulences. They want to make sure that spreads on their sovereign bonds continue to fall. Furthermore, in the absence of credible firewalls to protect those countries from a sudden liquidity crunch, financial markets are still too jittery. They are sensitive to what happens in Athens, and the markets are still skeptical of assurances that Greece is a unique case, one which will not be replicated elsewhere.
The next steps need to be taken quickly. At the end of February, the ECB will inject more liquidity into the banking system and, just as importantly, EU leaders will gather in Brussels a few hours later to make a decision on how to boost the firewalls needed to protect other member states from contagion. That is why the upcoming European summit in March plays such a crucial role in decoupling Greece’s fate from the rest of the euro zone. Germany has told its partners that it is willing to start a discussion on whether to commit more money to the bailout fund. But a discussion is not a decision and non-European countries, such as China, have signaled that they are only willing to commit more funds to the European rescue mechanism and the IMF, if the Europeans act first. Politicians on both sides of the Atlantic hope that the combined force of the European Stability Mechanism (ESM) and a strengthened IMF to the tune of approximately 1.25 trillion euros should provide enough firepower to convince markets that it is time to move on.
Timing the next steps properly is crucial to assuring the success of the plan. The Managing Director of the International Monetary Fund (IMF) Christine Lagarde, one of the leading advocates of a stronger permanent rescue mechanism, has now begun resorting to a gentle form of blackmail in order to make sure that no further delays slow down the process. Lagarde has linked a decision on the IMF’s financial contribution to the Greek bailout deal with the results of the EU summit in March. If Germany torpedoes attempts to strengthen the bailout funds, the IMF could very well decide not to contribute. Such a decision would risk derailing the deal. Berlin would bear the full brunt of the blame and face isolation within Europe. In fact, ahead of the March meeting, most triple-A rated countries, traditionally inclined to back Germany, have already signaled that they will support strengthening the firewalls.
Despite her reluctance to act when under pressure, saying NO to this crucial element of the crisis fighting mechanism is a risk that Angela Merkel is unlikely to take. After all, she too wants to divorce Greece’s uncertain political destiny from that of Germany. Indeed, in order to make sure the last act of the almost inevitable Greek tragedy plays out without repercussions for her own political legacy, she will have to compromise on the bailout funds.