The Greeks and their EU allies have been bearing gifts. Should we celebrate or beware?
The party got started at the end of June, when markets realised the Greek parliament would pass the necessary budget measures to unlock the next round of European Union and International Monetary Fund funding.
The fundamentals of the situation had not changed one bit and everyone knew it, so the party was short-lived.
The corks started popping once more with the arrival of a second gift, this time courtesy of the EU authorities and their second Greek stabilisation package.
It is doubtful this party will make it into the wee hours. The revised package is a step in the right direction but despite the language used to launch it, it is still a long way short of being a grand plan.
The stability fund has not changed in size but it has finally got the flexibility it needed to be an effective policy tool. You could say that only now have we got the fund we thought we were getting last summer.
The most radical part of the package, the acceptance of a selective Greek default, is in danger of falling between two stools. It has set a precedent for a eurozone sovereign default but without shaving enough off the debt to solve the problem.
It is no surprise that so far it has not succeeded in its key objective of checking contagion. Spanish bond yields have not fallen back below the 5.5 per cent level, which had been the resistance level before this most recent bout of turmoil.
If the recent Greek saga shows anything, it is that the old adage holds good, if you owe the bank £1,000, you have a problem but if you owe the bank £1m (or in this case €345bn), the bank has a problem.
By ruling out a Greek default in the early stages of the crisis and staking the credibility of the European project on this principle, the EU dug a hole for itself and has been busily digging ever since. It has given the Greeks the ability to hold the eurozone to ransom. Others may follow.
It is clear we have entered phase two of the peripheral eurozone debt crisis.
Phase one involved recognition of the problem, with the inevitably piecemeal solutions being left to the incumbent politicians and economic institutions.
Phase two has seen the crisis move into its political phase. In Spain, Ireland and now Greece, electorates have vented their spleen by slinging the politicians they blame out of office.
However, this has not produced any discernible shift in policy because, broadly speaking, the political elites are all wedded to the same utopian principles.
Phase three is the denouement. Something has to give. Either some of the sacred cows will have to be slain by way of a proper default, looser money, fiscal sovereignty or maybe the unity of the euro itself, or the electorate’s fury at its own impotence will deliver something much worse.
We are yet to see any debt crisis that has been resolved purely through the application of more deb. So far, the EU/IMF’s cunning plan is to kick the can down the road, buying the European banking sector time to rebuild its reserves before taking the inevitable hit from a Greek writedown. The latest stability plan has stuck to this format and has applied an even bigger boot.
The problem is that this particular can gets bigger every time you kick it. The second problem is that this ploy can only work if people do not know you are doing it. There is no real incentive for governments to meet stringent borrowing targets if they know the debt is already unmanageable and will be forgiven in the end anyway.
More important, it stands to make the eurozone banking sector a zombie in waiting. Already there are signs of European banks finding it increasingly hard to find funding outside of the eurozone.
However, just because a convincing solution has not yet been found does not mean one does not exist. Even though the Greek debt numbers are getting large relative to the capital base of the European banking sector, and twice the size of the Lehman’s default, they are eminently affordable at a euro-governmental level.
The most recent plan was another missed opportunity but the policy options are still there. A proper restructuring of debt and the use of EU-backed collateral either to recapitalise the banking sector and/or issue something similar to Brady bonds, should do the trick.
This would need to come in conjunction with a shock and awe stability package for those countries, such as Spain and Italy, where a default really cannot be countenanced, thereby confining contagion to the peripheral states.
All that is required but is so far sadly lacking is the unity of purpose and political will. We will almost certainly get there but it will probably be further down the road.
Europe will continue to be stalked by the shadow of a latent banking crisis in a way not dissimilar to Japan in the 1990s. As long as this is the case, it will be too early to buy continental European banks.
The risk of catastrophic contagion will persist and needs to be closely monitored through credit spreads. If the status quo persists, it will constrain credit and therefore growth across the eurozone as a whole but with uneven effects. Growth differentials within the region will become even more pronounced as funding will flow to the stronger areas and bypass the weaker ones.
By way of illustration, Spain’s risk-free rate as expressed by the 10-year bond yield is now just below 6 per cent. Real growth this year is expected to be around 1 per cent and inflation 3 per cent, giving a nominal growth rate of 4 per cent. Therefore, real interest rates currently stand at 2 per cent, meaning monetary policy is tight.
Run the same numbers by Germany and you get a very different picture. A real interest rate of -2.6 per cent and a startling 4.6 per cent real interest rate advantage in favour of Germany and this is before you consider the exacerbating effect of corporate credit spreads.
In light of this, one can expect corporate Germany to continue to eat the lunch of its weaker European brethren. Maybe this will help Germany’s politicians sell the cost of the project to their public but it is hardly a recipe for European harmony and stability.