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Fiscal discipline needed to avoid Greek tragedy - John Redwood Comment

February 02, 2010

Last week markets took fright at the mountain of money Greece wants to borrow to pay its government bills. It needs to borrow about the same relative to its National Income as the UK. The markets have pushed the price of Greek government bonds down, so Greece now has to pay twice as much interest as Germany to borrow the same number of Euros for ten years.

Greece cannot devalue within the Euro. The UK has already knocked one fifth off the amount it has to repay foreigners who lent it sterling cash by devaluing by a fifth over the last couple of years. Greece is saddled with paying back Euros, which have been more stable against the strong currencies of the lending nations.

There are five possible options for Greece from here:

1. Leave the Euro and devalue. That cuts the amount of real money they would need to pay back, would make their exports more competitive and their imports dearer, leading to a shift from consuming too much at home to working harder for foreigners abroad. They would still need to cut their deficit by cutting spending, as they would still need to borrow to pay some of the bills and they would no longer be able to offer Euros for repayment. Without the backing of the Euro they would either have to pay a higher interest rate, or cut spending substantially to rekindle confidence.

2. Stay in the Euro and accept the discipline of the club. They are meant to keep borrowing down to 3% of their income. Instead it has soared to 12.7%. They could cut their spending substantially, restoring confidence and limiting the amount they need to borrow. Their interest rates would return to similar levels to German ones once confidence was restored, but that could take time and long period of discipline.

3. The strong countries within the Euro zone could lend them the money they want to borrow on better terms than the market, or give them grants to see them through this bad patch. It is traditional in mature currency unions where there is also a single government for the richer parts of the union to send tax revenues to the poorer parts to help them.

4. There could be a deal. Germany and her friends within the Euro zone could agree a package, where Greece cuts her deficit by spending cuts and then is eligible for some grants, loans or subsidies to make up the rest.

5. They could all decide to do nothing. Greece would have to pay more to borrow internationally, and would gradually have to take action to curb the deficit. Otherwise the interest rate she had to pay might become so penal the markets forced a crisis, requiring action under one of the four options above.

I think Option one, leaving the Euro, is unlikely. Greece is keen to stay in, probably hoping for protection from her own folly by belonging to the larger club, and hoping against hope for more loans and subsidies from within. Whilst some in Germany and France might see going back to a core Euro as an attractive and more stable option, the overall balance of opinion in the EU is likely to want to keep Greece in. If Greece left, the positions of Spain, Portugal and some others would also be in question. It could lead to a messy unravelling of the wider Euro project.

I suspect Option 5 is also running out of room, as the markets are close now to forcing action to correct the deficit or to force a  bail out for Greece.

I would think Germany unlikely to simply offer to fund the excessive Greek deficit. It would be an open invitation to all the other ill disciplined Euro members to run up big debts and ask the centre for easy money to pay the bills. It would also start to place too much strain on Germany herself, as Germany is not without her own economic problems.

So that leaves the two options of tackling the deficit herself or doing so with European help and assistance for meeting various targets.

The whole saga shows the problem of premature currency union without proper arrangements in place for transfer payments and common fiscal policy. The Euro is becoming a system to try to impose disciplined  policies on the periphery, as Ireland, Greece, Spain, Portugal and even Italy have to rein in their excesses to live within the Euro scheme. Their reluctance to do so creates unemployment and lower incomes in each of them, and will generate a series of debt crises and economic crises as they push against the need to control spending.

Greece has a simple choice. Either live with German discipline, or run an expansive fiscal and economic policy and be at the mercy of markets. The Euro is not the free lunch some members thought it was going to be. It does not give a right to badly run countries to borrow at German rates of interest. You cannot guarantee single currency success unless you first create a single fiscal and economic policy. The EU thought that budget discipline could be administered by guidelines and rules, but several members have greatly exceeded the limits the EU wanted to impose on debt levels.

Currency markets have cut the value of the Euro against the dollar as a result of these events. Some even in Germany will be relieved, as even German exporters have found the recent level of the Euro tough going in limited world export markets. The Eurozone continues to have problems, both as a result of the very wide range of fiscal policies being followed, and from the ageing population. We recommend keeping out of shares in this region whilst they hammer out a solution to the Greek problem, and think about the plights of Spain, Portugal and Ireland.
 

Regards,
Evercore Pan-Asset Team