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Reality Check in the Eurozone

Another day, another announcement of another quick patch for the eurozone crisis, another relief rally on world markets.

It appears, however, that this deal is no more of a final solution to the crisis than any of the countless other agreements that European leaders have reached at various stages on their long Trail of Tears. Some of the biggest questions have once again been kicked down the road — like how much Greek bondholders will actually get for their bonds, how much money the EFSF will actually be able to use and, basically, the whole set of vexing questions hanging over Europe’s future.

The truth hurts, Eurozone leaders are coming to realize — especially when the truth involves hundreds of billions of dollars. The central fact of the current crisis is that someone must absorb these losses — the real question now is who pays. According to the Washington Post, so far the answer has been the IMF and the Eurozone member states, whose bailout lending to Greece has been used to pay off private bondholders — mostly European banks — to the tune of $52 billion.

Greece is so hopelessly indebted that someone, be it the banks receiving the bailout funds or the taxpayers who provide the funding, must lose a lot of money and fast. Lenders to Spain, Portugal, Italy and possibly some others stand to lose even more money, though perhaps not quite as quickly.

How the process plays out will matter a great deal. At present, the use of emergency money to payout the banks amounts to a subtle private sector bailout. Taxpayers are told they are bailing out “Greece”, but the actual money goes to banks and other private holders of Greek debt.  This amounts to a silent bailout of the European banking system, disguised as a bailout of troubled European states.

A more transparent process, which the Germans among others have been pushing for, would see private bondholders take their share of losses, which would likely wipe out the equity in many entities, followed by a taxpayer funded recapitalization of those institutions that find themselves in trouble.

This has the merit of being honest and transparent — though in the eyes of many European policy makers (who encouraged banks to bulk up on sovereign eurozone debt through deeply flawed bank regulations), honesty and transparency are exactly what the Euro process doesn’t need.

There are, however, some problems with this approach.  One is France.  Hiding the dire state of the French banking system seems to have been a strategic objective of the entire French establishment throughout this saga; one is left to assume that this is partly because they think this will make it easier to use German and other foreign money to cover French losses and partly because they fear the economic and political costs that would follow full public disclosure of the parlous state of French finance.

A write-down/recap approach forces France to fight, hard, for money; if every European country has to recapitalize its own banks after a hefty haircut on Club Med bonds, France will be hard pressed to pay, and could turn from an AAA rated pillar of the European community into a low rated country with a debt and solvency crisis of its own. That would leave Germany standing alone with a handful of small Nordic economies as the only stable countries in the zone — something that the eurozone could probably not survive.

There’s another problem with the write down and recap approach: what happens to new bonds from Club Med countries like Spain, Italy and Portugal when Greek bondholders are losing their shirts?  Budgets in Europe are very far from being balanced, and the debtor countries are bringing wagon loads of new IOU bond issues to the financial markets all the time.  Once Europe decides to “bail in” the private sector, private investors will stop buying all but the absolute top rated European bond issues.  “Europe” will have to fund these countries itself, or watch them fail to pay their employees and make welfare state payments on time.

This means that the plan the European leaders come up with for Greece demands a more comprehensive approach to the eurozone as a whole — and that involves even more pain, and even sharper squabbles about who must pay what. And it also gives bond buyers huge leverage in negotiations over what to do about existing debts.  If they think they are being pushed to absorb too many losses they can threaten a buyers’ strike and refuse to buy new PIGS-issued debt.  European authorities are trying to wind down the Greek Ponzi scheme while not scaring the customers away from the Spanish, Portuguese and Italian schemes that are still going on.

The bondholders, of course, are playing hardball — and why wouldn’t they?  They want as much of their money back as they possibly can get.  What appears to be going on now is a classic European fudge: Angela Merkel needs a deal that looks tough on bondholders and the ‘private sector’ while she isn’t willing to push Europe over the cliff — which a genuinely tough debt write down might do, for the reasons cited above.

The ‘solution’ seems to be that there will be a big headline cut of 5o percent in the nominal value of Greek debt, but there will be various sweeteners attached so that in reality the bondholders won’t lose much more than they had already accepted back in July (when Europe made its most recent “grand bargain” advertised as solving the problem), but everyone hopes the taxpayers won’t read the fine print.  The nature of those sweeteners will be worked out in negotiations between bondholders and governments; presumably the European leadership hopes that by then the German, Dutch and Finnish publics will be so distracted by other news that they won’t pay attention.

Viewed from one angle, this is an elegant solution to an intractable problem.  Merkel gets a headline, France gets the money, the bondholders don’t walk away from the table and everyone moves on.  And it did get the world economy through another rough week.

But elegant European solutions have been falling flat during the two year financial crisis.  One feels that there will be more deadlines, more stock market swoons, more frantic summits and more pain before Europe succeeds in moving past the disaster its failed currency and regulatory policies so assiduously labored to build.

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  • John

    I agree but there is a lot more wrong with this deal than suggested. Where is the 1 Trillion? They don’t have it and have to beg China etc. to get it. What about the Billions spent on CDSs? Sound familiar, borrowing more to cover debt? Not a single pvt bank has accepted the deal and by the way, no hair cut (head cut) for IMF loans! Your last paragraph suggests Europe will eventually move past this. Well yes, maybe post WW III! How can they move past this? The US is next and quickly. This is the capitalist equation coming to fruition. Growth growth growth with exponential population growth and dwindling finite resources? How on earth can anyone imagine or not realise that this bubble is going to burst in a big way. I have begin to realise most humans are in fact ostriches. Recent estimates suggest that around 6 Billion people on this planet only exist because of fossil fuel. Oil in a word pervades every aspect of our lives. Oil, food, arable land, fertiliser etc. etc. all running out fast. This so called “crisis” will be laughable in the future compared to what is coming. This is just the first red flag.

  • Mrs. Davis

    The problem is much more the deficits than the debt. If the deficits were ended, by abandoning the blue model, the debts would easily be taken care of. As long as the deficits remain or grow, the debts will grow. Until the creditors stop lending. Then the deficits will end. Rapidly. Painfully. That’s what it will take to get people to kick the blue habit. Worse than cigarettes.

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