While EU leadership struggles to agree on policy to keep the eurozone intact, investors wonder if uncertainty in the financial markets will soon push the eurozone beyond the brink of political manageability into a global financial market panic.
Everyone knows that Greece is teetering on default. Earlier this month, IMF President Christine Lagarde said that we are in a “new, dangerous phase of the economic crisis.” In Europe, slowing global growth and falling government revenues accentuate the Euro debt crisis as weaker countries struggle to re-pay burdensome debt. Ireland and Portugal, once on the “next to fail” list, have made improvements and have the benefit of the doubt for now as to whether or not they will eventually default. Greece, on the other hand, remains in the spotlight. Financial markets now expect a Greek default due to poor economic fundamentals, slowing revenues, rising costs of financing Greek debt, and the inability of political leadership to find a solution 18 months into the crisis. By market measures of risk, a Greek default is virtually certain; the questions are how and when a default will occur. Now is the time for EU leaders to accept a Greek default and act decisively to preserve the Euro.
How will Greece default?
An “orderly default” would mean a process managed by the EU and the IMF that would include bond exchanges that drastically write-down the value of the debt. Alternatively, a “disorderly” default would be provoked by an unexpected event such as Greece not qualifying to receive “bail-out” funds, or an EU country not approving a “bail-out” measure at home. It could also be sparked by the perception that EU leadership is not implementing timely or credible measures. The “disorderly” scenario would result in immeasurable losses and consequences to the global economy. Currently, given the lack of confidence in EU leadership and extreme financial market volatility, it appears we are more likely on a path towards a disorderly default.
It is time for EU leadership to act decisively.
The best policy measure for EU leadership is to acknowledge what financial markets perceive, that a Greek default is imminent and plan for it. EU leadership must accept that, although no one benefits from a Greek default, it is also apparent that the eurozone is deconverging economically based on the realities of a diverse Europe, accentuated by the on-going global financial crisis, with no apparent solution within the constraints of the eurozone. Although on-going measures to keep the eurozone intact, fiscal integration in particular, may be long run solutions to the eurozone’s structural problems, the immediate crisis is that Greece is on the verge of bankruptcy now and financial markets see no credible solution in place to stop a default. It is in everyone’s best interest that a default be planned and “orderly,” to the degree possible, to limit its damage to the eurozone and global economy.
Many fear that a Greek default would risk “contagion,” the transmission of the shock of the default to other countries given the inter-connected world of financial markets, currencies, trade, and banking. The fact is that contagion already exists, and is likely to escalate in the absence of a credible plan. Contagion of sentiment is also apparent as the gloomy outlook for Greece and the eurozone permeates fear across financial markets and business decisions around the globe.
The best measure to stem contagion going forward is to bolster the capital in the banking system and address other banking weaknesses given the inter-relationship between the real economy, credit, and the operations of the banking system. Though it is easier said than done, IMF and EU finance ministers have evidenced determination to recapitalize the European banking system as a means to create a “fire wall” for Greek contagion to France, Germany, Italy, and Spain. Chancellor Merkel would more likely be able to get support from the German electorate and her own party for funds to bolster the European banking system than for more funds to bail-out Greece.
There is a consensus that EU policy will defend Italy and Spain. The resources do not and will not exist to save these by “bail outs” using the existing mechanisms and rescue funds as their economies and bond markets dwarf those of Greece in size. If Italy and Spain are not able to manage to stay in the eurozone due to deteriorating economic fundamentals and rising financing costs on their debt, then the eurozone will not be able to function and the Euro will no longer exist.
Under the orderly default scenario, Greece would likely have to leave the eurozone, but that is not a certainty. One scenario is that Greece defaults and stays, but at the cost of much of its sovereign decision making being lost to the EU and the IMF, likely not acceptable to the Greeks. Alternatively, leaving the eurozone would be catastrophic for Greece for many reasons including the devaluation of a new currency and hyper- inflation. In either case, prolonging the austerity measures currently imposed by the EU and IMF is also a long and painful road to follow, one that is unlikely to avoid eventual default. Greek debts appear insurmountable.
Will the eurozone survive a Greek default?
The eurozone will survive a Greek default and will likely emerge with stronger institutions as a result. It takes a crisis to provoke real change; and it is time for real change because we do have a real global crisis. The political process of managing the Euro debt crisis may bring constructive change to the eurozone in the form of eventual fiscal integration, stronger EU institutions, and global cooperation. The fiscal unification solution is a long and arduous road that will take years of negotiating and many new agreements, but is now beginning to emerge in the form of the European Financial Stability Facility, soon to be approved to receive expanded powers. Global coordination and pressure to find a new structure for the Eurozone is certainly forthcoming. The IMF can be counted on for a supporting role. The Federal Reserve stands ready to support the European Central Bank. The Chinese will be ready to buy Italian and other weaker countries bonds when credible EU policy is in process. Eventually it may be possible to expect debt buybacks and bond exchanges from other “emerging market” countries. Even the private sector, awash in cash from years of low interest rates, will be ready to invest again when credible policy emerges from EU political leadership. The next step is for EU leaders to face reality and take decisive action: It is time to accept that Greece is bankrupt now and manage an “orderly default.” The eurozone will emerge stronger, as result, and the EU recognition of the reality of Greek insolvency will likely be an uplifting relief for financial markets, as well.