piątek, 22 stycznia 2010 15:27

Far from weakening the euro, the Greek tragedy reveals the currency’s steely edge

Adam Jasser

With devaluation out as a policy tool for euro zone members, structural reforms are the order of the day across the EU, with Greece and Spain being just the first battle grounds in this process. For 10 years, the euro gave a number of countries a free ride on the back of the global economic exuberance. Now, it is acting as an agent of change and  deeper economic and political integration in the EU. 

 

Haven’t we heard it before? A year ago it was tiny Latvia (0.2 percent of European Union’s total economy) who was supposed to drag first its central European peers and then the entire bloc into an abyss because its overinflated economy finally and deservedly burst. Pundits on both sides of the Atlantic predicted a major contagion and a domino effect comprising sovereign default, banking system collapse and massive devaluation in central Europe followed by a banking crisis in the entire EU. 

These predictions of doom coming from respectable sources did influence markets and we saw a concerted sell-off in assets of countries in central Europe, including those that remained healthy or even defied the global downturn. In the end, Poland (half of central Europe’s entire economy) may have grown 1.7 percent last year, while Latvia, the region’s basket case,  survived. The banking crisis was averted on the back of an IMF-EU bailout, its currency peg (the pillar of credibility) was saved and the public swallowed (even if with much anger) the bitter pill of deflationary adjustment administered by the IMF and the Commission.

Now, it turns out it is going to be Greece (2 percent of the EU economy)  not Latvia which will bring down the euro zone and bury chances of a European recovery.  That is why, we hear, the EU must act and act decisively, otherwise its precious euro will not survive. The break-up of the euro zone is already being priced in by the markets, the doomsayers say, and not surprisingly this is fuelling even more short selling of European assets.

EU decision makers should refuse to heed these calls for “ immediate action” for a number of reasons.

First, I remain to be convinced that Greece poses a systemic threat to the EU economy. Like in Latvia’s case before, there seems to be no obvious transmission mechanism for the feared contagion. True, costs of borrowing might shoot up in a number of weaker EU members as they have in Greece but this is a natural way of exerting market pressure on governments to do the right thing. If the currency risk is taken out of the equation thanks to euro zone membership, this is a relatively benign risk for the euro zone.  Creditworthiness can vary within a single currency area in the same way it varies between municipalities in a country. 

Second, the small size of the Greek economy, modest trade flows and low exposure of major European banks to Greece limit the potential for contagion. 

Third, there is a fundamental flaw in the perception of  risk associated with a potential Greek default. The argument goes that a default would require Greece to leave the euro zone and increase pressure on other peripherals such as Spain or Portugal. In the extreme case, they might also be forced  to quit the euro zone to restructure their economies through a devaluation rather than deflation. Many analysts doubt this scenario would come to pass but even if it were, I fail to see why an exit of its weakest members would be harmful to the euro zone. The reverse logic would imply that the presence of  Greece inside the euro zone boosts the currency’s credibility. Any takers for that?

So let’s be clear – the risk associated with Greece’s hypothetical exit from the euro zone is squarely sitting with Greece itself (hence the premium it pays on its bonds). Far from shorting the euro, investors should be buying the currency if the euro zone exit scenario for Greece came closer to reality.  Of course there is a question of the point at which a potential euro zone exodus would gain critical mass to undo the currency. Would Spain, Portugal and Greece be enough? Probably not. How about Italy and Ireland? Possible, however, even then investors might judge that a euro zone with Germany, France and the Netherlands at its core plus Finland and a few advanced central Europeans might not be a bad thing at all.

Of course there is the argument that a market run on the euro, even if based on faulty fundamentals, may be so violent that EU policy makers must act preventively now to reduce this risk. This looks like an exaggerated concern. The euro might simply be overvalued and a market-led correction may bring it closer to levels justified by the fundamentals.

So if the intervention to rescue Greece is not imperative for the entire euro zone, is there a compelling argument to do it for the sake of Greece itself? Is it something that is necessary from the point of view of European solidarity?

In principle, yes. In practice, the question is how to do that without causing more harm than good to Greece and the entire system.  We must recognise that in the absence of a political mechanism that would allow a receivership of a bankrupt member country by the European Commission, there simply are no good tools the EU could use to help Greece without compromising its principles. The tool everyone thinks about –  some form of an EU loan – is bad because, without the possibility of attaching binding conditions,  it would fail to deliver real reform, create moral hazard and prompt accusations of double standards.  After all, Latvia, Hungary, Ireland all took serious measures to correct their structural imbalances and in the case of the two first, loans granted to them had rather mighty strings attached to them. A loan to Greece would be de facto unconditional. The only punishment the Commission could use would be blocking some funds for Greece in the future, which would be sort of funny given it would have already been taken for a ride by giving the loan in the first place.  And please, please do not talk about peer pressure at the Ecofin or Eurogroup.

Old good IMF
Does that mean the EU should let Greece sink if it came to the brink of default? No, it should not. But it must choose wisely when to intervene and how.

On timing, the EU should not rush in prematurely. Let the Greek government and the Greek people chew on what had happened to their country. It is alarming to see how little understanding there is in Greece today that her problems are home-made and reflect decades of mismanagement, denial and misconstrued social justice. Greece needs a lot of soul-searching and reflection to make itself viable for the future. The debate may be violent in line with the unfortunate tradition there but it is probably unavoidable because without some national unity around the way out, not much can be achieved.  Only a Greece more than less reconciled with reality will be able to use any bailout effectively. Otherwise, the rescuers will get all the blame for the necessary adjustment from ordinary Greeks, whose anger will be leveraged by the government to water down its commitments as the going gets tough.  Greece’s track record should leave no one in doubt about the likelihood of such an outcome although in George Papandreou, it has found a leader who might have the integrity and skills to pull this off.

And it must be the Greek people, not Berlin, Paris or Brussels,  who take that ultimate decision of all – whether Greece should leave the euro zone and return to the Bronze Age.  It’s deflation or devaluation but either will be better than another fudge.

As to how should the EU intervene when the time comes, there is a path it had already chosen for others – a joint action with the IMF.  There is a lot of argument that using the IMF to bail out a euro zone member would damage the currency’s credibility. A false and unnecessary sense of pride.  Markets trust the IMF’s ability to enforce bailout conditions more than the EU, which for many is the epitome of fudge.

After all, this is what the IMF has been created for.  Of course the EU and the euro zone should look at ways to enhance the toolbox to be able to deal with such situations in the future, but unless it can do so within the next few months, it should resign itself to combine forces with the IMF in any rescue of Greece. Greece must be made understand that this is the only option at the table at the moment and that it will be up to the Greek government to apply and take responsibility for the consequences before the Greek public. Such a solution has the virtue of being fair and consistent with other rescue packages in the EU. If Greece got different treatment than Latvia or Hungary, the EU would face the ire of new EU members for applying double standards, especially, that some of them are much closer to meeting euro criteria than Greece. 

The division of labour would be for the EU to provide the bulk of the rescue package and outsource the policing and enforcement to the IMF. Both sides should have less problem agreeing the conditions Greece would have to meet than in Latvia’s case because there would be no disagreements on one fundamental issue – the exchange rate.  It is a well known secret that the IMF wanted to add a devaluation to the policy mix imposed on Latvia, while the Commission favoured sticking to the current peg to the euro as an anchor of stability. In a rescue of a euro country, there would be no debate about devaluation and hence an easier agreement about a deflationary way out (which seems to support the Commission approach to Latvia, by the way). That would make a coordinated EU-IMF rescue effort quite robust.

The euro’s steely edge
When the euro was created 10 years ago, several countries made a dash to join with a token reform effort to satisfy the entry criteria. Once in, they just enjoyed the ride. This led to major imbalances in the euro zone and huge differentials in growth and inflation rates.  The euro was a one way bet for the weak members, who had the benefit of low interest rates and risk profiles appropriate for Germany. The crisis turned this upside down, showing nations the other side of the bargain and the euro’s steely edge – it punishes for a loss of competitiveness and enforces reform by excluding the devaluation option. Deflation and structural reforms are the only course left. Cutting wages and public spending and accepting low growth rates for several years will not come without pain and social tensions but if reforms are done promptly and wisely, they will restore competitiveness to individual countries and help achieve deeper real convergence within the euro zone.  The condition is that we must let the process run and any intervention such as a rescue package must be constructed in a way as not to blunt the very mechanism which is at work here, making the case for further economic and political integration compelling.  Not for nothing, the euro was right from the beginning seen as a political not just economic endeavour.

The EU is therefore right to begin pondering how to enhance policy coordination and strengthen the community’s ability to fine tune individual economies. Convergence criteria will most likely have to evolve to include a limit on current account balances and an enforcement mechanism for sticking with the rules will have to be put in the hands of the Commission.  But all of that falls short of what is really required. What the euro is clandestinely working towards (like a sleeper planted by the EU “federalists”) is a far-reaching unification of the social and economic models that today function in the EU.  The existence of variously efficient pension systems, labour market rules, business environments and tax regulations are the root cause of the imbalances inside the euro zone. It is not a coincidence that countries with advanced structural reforms and relatively strong fiscal positions seem less ready to bail out Greece than those who know their own economies suffer from similar structural problems even if on a much smaller scale.  What the EU needs, is a concerted move towards best practice and more performance-based labour and social models that are compatible with the EU’s demographic trends and competitive pressures resulting from globalisation. The euro is the catalyst of such change and as such will exact a rising price on those who drag their feet. Ultimately, they will face the same choice as Greece today – bite the bullet or quit.  Either way, the euro zone will emerge stronger from this process. What remains an open issue is the number of EU countries who will share this success.