Tuesday, 21 February 2012

The Eurozone Veneer

Sometimes, someone writes something that is so spot on it simply cannot be bettered and it is pointless trying. This from Sky News today:

"Greek finance minister Evangelos Venizelos was right in his claim that Eurozone ministers would finally agree a second bailout for the country - but the deal still leaves questions unanswered.

The crunch summit could prevent the country from missing a 14.5bn euro (£12bn) coupon repayment this time next month, in turn avoiding a messy un-negotiated default. The deal should plot a path for Greece to bring its national debt back down towards 120% of gross domestic product. What is not at all obvious is that this does anything to remove the uncertainty hanging over the Greek economy. Yes, it will essentially be saved from having to raise cash in the private capital markets, for the time being. But what will be left of the Greek economy, or indeed society? And what lessons does this provide about the euro project? The omens are not promising.

Here are six questions - or problems - that will not be answered by the deal.

1: First, and perhaps most worryingly, the Greek economic collapse has now reached almost unprecedented proportions. The country's economy shrank by 7% last year. Before the crisis, the country's annual economic output was about the same as Switzerland's. By the end, it will be barely bigger than the Czech Republic's. In all, economists expect it to shrink by as much as 25-30%. That would be the biggest single recession ever - by far worse than the US experience in the Great Depression, worse even than the collapse of the Argentinian economy during its own default crisis. An economy cannot collapse by this much without causing direct erosion of families' incomes, particularly given the particular variety of contraction opted for by the euro ministers is austerity. So do not be surprised if those riots we are seeing so regularly in Athens continue. The real worry, of course, is not just riots, but the prospect that the Greek people eventually lurch towards a more extremist government, or the military take matters into their own hands. That, after all, is precisely how many economies reacted to austerity in the 1930s, as this recent paper from Barry Eichengreen shows.

2: The deal will not necessarily reduce Greece's overall debt to a sustainable level. The target is to cut total debt - as a percentage of national income - to 120%. But there is plenty of evidence that this level is simply too high for an economy with the growth problems Greece is exhibiting. Moreover, that 120% seems to be more of an aspiration than anything else, relying on hopelessly optimistic growth and budget projections for the coming decades.

3: Even if this deal is successful in averting a messy default, it will not necessarily prevent a so-called 'credit event'. Private sector bondholders will take a 'haircut' on their holdings of Greek debt, which will be viewed as a default by credit ratings agencies. It will very possibly be viewed as a 'credit event' which triggers credit default swaps - the kind of opaque financial instruments which caused such fear after Lehman Brothers collapsed in 2008. Now, we are told investors are prepared for this contingency given how much time they have had to dwell on it, but it would be foolhardy to expect the entire process to go smoothly.

4: Greece is still deep in debt. It is just that much of the debt which was previously owed to the private sector is now owed to other euro governments (and the ECB). Gavyn Davies runs through the numbers here. Mr Venizelos will not have any closure until the country reduces that debt-load. That is not going to happen through growth, it is not going to happen through devaluation (unless Greece leaves the euro), so it will have at some point to happen through default - either another, more convincing default or high inflation across the euro area. The latter is unpalatable for the Bundesbank-influenced ECB. But, in the end someone will have to take the hit. It is still unclear who that will be, except that the structure of the current deal imposes all the pain on the Greek people.

5: The euro project is clearly failing. It was supposed to encourage its member states to become more closely aligned economically. As it stands, their competitiveness has diverged. As long as this endures, Greece and its Mediterranean neighbours will have to keep receiving subsidies from the richer euro members. Greece may have been an outlier in that regard, but many of its traits are shared by Portugal, Italy and Spain. Now the Greek crisis is temporarily papered over, expect investors' attention to swing back to them.

6: The ECB has bought the Eurozone nations some time by flooding the continent's banking system with cash through its Long Term Repo Operations (LTRO). It is likely to pump an extra slug of money to add to its half-a-trillion euro total at the end of this month. However, this cash will not last forever (the loans have a term of three years), and does not represent a permanent firewall for the single currency. At some point, investors will lose patience and realise such measures fall far short of a meaningful solution for either Greece or the currency area's woes."

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