The European debt crisis has remained stubbornly in the headlights in the past few weeks, with market attention focusing once more on Greek financing needs, and fears resurfacing that contagion could hit the likes of Spain, Belgium or Italy, especially following the recent regional elections in the former. Normally, these market jitters would reflect the fact that no one is quite sure how the crisis will play out, given that policy makers have yet to spell out what will happen in the event of Greece needing more money. But, very recently, events have taken a more sinister turn.
The bottom line on Greece is the same as it ever was. Under the original bailout plan, Greece was always required to come back to financial markets at the start of 2012 and start issuing long-term debt again. Given that yields and spreads have continued to rise – at the time of writing, the yield on a benchmark 10Y Greek bond was almost 17%, far too high for Greece to cope – that now looks all but impossible. So the euro area has a simple choice: either back Greece with more cash, or let it default. The problem with the first option is that Greece would literally need hundreds of billions of euros to buy it enough time for the economy to get back on its feet and start growing again, which is what would need to happen. The problem with the second option is that the potential consequences of a default – and, for it to be meaningful, it would need to be a proper haircut rather than just a ‘reprofiling’ – are large, especially if it is mismanaged. And, thus far, European policymakers have hardly covered themselves in glory when it comes to managing financial markets.
Option two still looks like the more likely to me – I just don’t think there is the political will in Europe (ie Germany) to up the ante on its Greek support. But, provided policymakers actually think through the issues properly, which in practice means getting substantial IMF advice and support, the fallout from a restructuring/default may not be disastrous. The European banking sector is in notably better health than it was a year ago, and provided temporary support for Greece could be rolled over for a bit then default could be manageable. My sense is that European politicians have been gradually moving towards the same conclusion.
The ECB, however, has not. And in the past week it has thrown several pounds of semtex into the ongoing deliberations. In particular, in the past week a succession of Governing Council members have lined up to say that any move to restructure or even reprofile Greek debt would mean that those bonds would no longer be acceptable as collateral in the ECB’s liquidity operations.
Quite why this would be the case is entirely unclear. The ECB has already torn up its own rulebook in order that Greek paper is still currently eligible and, if it wanted to, could easily make provision for Greek debt to be accepted after any default/restructuring. The ECB, after all, is the most independent central bank in the world – it even gets to decide its own inflation mandate, unlike the BoE and the Fed. But the Grand Lady of Kaiserstrasse has been against a restructuring from the start, and instead wants to see other Europeans extend and roll over financial support for Greece. (There is a suspicion in some quarters that its enthusiasm for this approach is because the ECB sees it as a way to move towards fiscal union via the back door.) The problem, of course, is that politicians don’t agree.
In essence, the ECB’s intransigence means that we are probably headed towards the endgame of the crisis rather more swiftly than many thought. Yes, a monetary union without fiscal union is problematic – but when the central bank and the fiscal authorities start arguing with each other in public, that is far worse. If the Bank of England and HM Treasury started tearing lumps out of each other, you would see the reaction in financial markets. And the risk is that, if the ECB stubbornly sticks to its guns, there is a much greater chance that the monetary union will break up. A Greek default would be painful, but would not imply that Greece would have to leave the euro. But if private Greek banks were unable to access the ECB’s funding operations, because their collateral (Greek government debt) was now ineligible, then left unchecked that really could push Greece into a full-blown financial meltdown. This, of course, is precisely the outcome that Western governments tried so hard to avoid in 2008 and 2009. Faced with that prospect, leaving the euro does potentially become a genuinely viable option – or at least potentially the best of a bad bunch – for the Greek government. At the very least, it would let the Greeks prop up their banks and avoid total disaster.
Hopefully, it will not come to that. European politicians are (probably) not daft enough to ignore the prospect of complete financial meltdown in Greece – and, if needs be, they could step in with financing for Greek banks via a variety of channels. But, even if it steps back from the brink, my faith in the ECB has been massively shaken. Looking beyond the current trials and tribulations of the eurozone, the central bank is supposed to be the guardian of the euro – not the architect of its destruction. The ECB is playing with fire.