Jim Stewart: Some likely outcomes can be anticipated from a recent speech by German Chancellor Angela Merkel:-
(1) There will be new rules and penalties for Eurozone members. The Commission and/or the member States will become more active in monitoring annual budgets. Aspects of the annual budget may be agreed/negotiated with Brussels. In the case of Ireland this is not necessarily a bad thing given our over reliance on tax expenditures as a policy instrument (See TASC: Failed Design). Some implications:-
(a) Those countries with largest deficits are likely to have the greatest scrutiny;
(b) Measurement of key variables and comparisons with other eurozone economies is key. For example, few international commentators have noticed that Ireland's net debt as a fraction of GDP is a little over one third the gross debt position. Many countries have large off-balance sheet financial liabilities (France, Germany and Ireland) because of the banking crisis. Should these be included in net debt positions?
(c) Negotiations and alliances with other Member States, active involvement in policy formation at an EU level, and persuasive argument, will become central for Governments that wish to deviate from EU (and especially eurozone) norms. That is a new political economy will emerge.
(2) A country using the Euro would be allowed to become ‘insolvent’. It is because of this risk that Greek bond yields have increased from around 5% at the start of the year to over 10%. This effectively means that there is minimal trading in Greek Government bonds. The rise in yield and fall in price also means that the market value of Greek Government debt as a percentage of GDP is far lower than the nominal value. Hence on a market value basis the ratio of government debt to GDP is far lower than the often quoted figure of 120%. The markets have solved one aspect of the Greek Crisis! Some implications:-
(a) Banks holding Greek Government debt will face large losses if the debt were sold. France accounts for €75.7 billion of Greek government debt, Switzerland €64 billion and Germany €43.2 billion (Anne Seith, Der Spiegel, 28/4/2010). Greek banks will face large losses. Conversely, financial assistance (especially the financial stability program) which prevents insolvency is of direct benefit to banks, which is why German and French banks have been required to contribute to the bail out.
(b) If Greece remains a member of the Euro, but becomes ‘insolvent’, This is likely to mean existing debt will be rescheduled, meaning the redemption date could be extended, or there may be a write down in the nominal value to current market values, or interest rates could be renegotiated down. This has implications for issuers of CDS instruments. Given the size of Greek Government debt many of these could in turn face liquidity/solvency difficulties, thus unmasking the false claim that such instruments provide “insurance”.
(c) But even with ‘insolvency’, an issue still remains - how will new finance be raised? One solution would be to issue Euro denominated debt by for example the European Bank for Reconstruction and Development (EBRD), and then hand this to Greece. This debt could then be ranked ahead of existing debt. Alternatives have been discussed, for example allowing the ECB to buy Greek debt directly. Proposals do not make clear whether this would be new debt (thus financing Greece) or existing debt thus supporting the market. ECB intervention is more likely to happen in the case of other countries affected by the Greek crisis such as Portugal and Spain, and in some lists Ireland.
(3) Proposals to expel a country from the Euro area as advocated by the German finance minister (Schaeuble) would require a renegotiation of EU treaties. This is unlikely in the short term, and such a proposal may be merely for domestic political reasons in Germany.
It is likely that key countries such as France and Germany will support other Eurozone countries if required, by providing loans. But the rules under which countries in the Eurozone will operate has changed fundamentally. There will be far greater emphasis on external control over budgetary decisions.
The main effect of the crisis so far has been a welcome devaluation of the Euro against Sterling, (partly reversed post the UK general election), and the dollar but an unwelcome increase in interest rates in countries such as Portugal, Spain and Ireland. It is also likely to mean the further evolution of the single currency area towards economic coordination and in effect fiscal transfers, although these take place via the ECB on loans at subsidized rates of interest.
These developments will require the development of a new political economy – the subject of the next post on the crisis by David Jacobson.