The EU Bailout: Too Much, Too Late

Includes: EWG, EWQ, FXE, IGOV
by: Felix Salmon

Is the massive EU bailout a case of “too much, too late”? At $1 trillion, give or take (depending on the highly-uncertain value of the euro), it’s certainly enormous: Mohamed El-Erian calls it “a completely new level and dimension” in terms of European policy response. But the late-night negotiations of European finance ministers might yet fail to pass muster with national governments. After all, as Kevin Drum notes, the $700 billion TARP bill was initially voted down by the House of Representatives, and this deal has to be ratified by not one but many different legislatures.

Meanwhile, Peter Boone and Simon Johnson have some very scary numbers about Greece in particular: it will have to cut spending by a whopping 11% of GDP; its debt-to-GDP ratio will rise to at least 149% of GDP in a best-case scenario; and realistically Greek GDP could fall by 12% between now and 2011. Now that’s a recession.

Meanwhile, Lee Buchheit and Mitu Gulati have a paper out showing just how easy it would be for Greece to default. Buchheit is the godfather of sovereign debt restructuring, and he notes that uniquely among countries in that position, most of Greece’s indebtedness is governed by its own domestic law:

No other debtor country in modern history has been in a position significantly to affect the outcome of a sovereign debt restructuring by changing some feature of the law by which the vast majority of the instruments are governed.

In this context it’s worth noting that Simon Johnson, who used to be the IMF’s chief economist, says that the Fund “floated in some fashion an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities”. What that means is that the idea is being seriously talked about at the highest levels — and that even if the Greek government isn’t going to crack right now, it has a clear “in case of emergency, break glass” Plan B temptingly sitting there for whenever the pain of recession becomes unbearable. With Lazard on board as sovereign advisors, a clear plan of action from Buchheit and the IMF comfortable in principle with a default, the path of least resistance is quite clear.

The obstacles to default would be the Greek banks, which would become insolvent overnight, the Greek pension funds and of course, the EU more generally, which is clearly putting up all these billions today in order to avoid any euro zone default. As Anna Gelpern says, “Greece’s political leverage to restructure may be limited, even if its legal leverage is considerable” — but only insofar as it considers EU and euro zone membership a blessing rather than a curse.

So while the EU’s trillion dollars is surely sufficient to prevent any country from having to default in the next few years, I fear that its enormity will only exacerbate tensions between the euro zone countries over the long term. They’re not all partners together anymore: now they’re bifurcating into the rich lenders, on the one hand, and the formerly-profligate debtors, on the other. The mind-boggling sums involved are only going to increase resentments both of the south in the north and of the north in the south.

Baruch has a great post on this, echoing Philip Stephens:

The Euro is at more risk than it has ever been. And for the new generation of politicians in France and Germany the compromises of the 1990s may not mean so much. We don’t know how much they are prepared to risk to defend the status quo. They don’t have direct memories of firebombed cities, of fathers not returning home, of mothers and sisters raped by the Red Army. I don’t think we’d have the same worry if Kohl and Mitterand were still around. We would trust them more not to f— about. Again, like the ECB, Merkel and Sarko are untried; their being in charge implies less risk, more uncertainty. And the French disengagement on this whole issue worries me.

To recast my matrimonial analogy, the parents have promised to bail their wayward children out of jail. And they think that the children will respond overnight with gratitude and with a fundamental change of behavior. Does that ever actually happen?