How should the Greek debt crisis be resolved?

On July 29th, two days from now, Greece will begin her deferred discussions over a third bailout of €85bn when prime minister Alexis Tsipras of the governing Syriza party will  meet again  the emissaries of the dreaded troika the European Commission, European Central Bank and International Monetary Fund in Athens. He has already capitulated to demands of Germans, after being threatened to be forced out of the eurozone in his previous talk, to repay the debt of almost $339 billion, which the International Monetary Fund now says that there is no way that she can reasonably pay it back – and this is, of course, after years in which the IMF, as part of troika, was a stern advocate of tough austerity policies.

There is no doubt that the Greek economy, which according to the World Bank data, has experienced a dramatic decline in the GDP of nearly 30 percent, from $354 billion in 2008 to $242 billion in 2013, after five years of austerity, recession and soaring unemployment with an overvalued currency, can ever hope to repay even a fraction of her debt. The country’s ex-finance minister Yanis Varoufakis has recently revealed that eurozone leaders demanded that Greek public assets be transferred to a Treuhand-like fund – that would be based in Luxembourg, and under the supervision of the Germany’s finance minister, Wolfgang Schäuble, would complete the fire sales within three years. According to him the new Geek finance minister Euclid Tsakalotos, were able to extract some concession from the troika so that the fund would be managed from Athens and that the sales could extend to 30 years.

It is important to be reminded that in 1980, Greece was among the less well-off member countries of the EU. Moreover, from 1980 to 1997, the annual GDP per capita growth rate in Greece was only 0.56%, the lowest among all future eurozone countries. This was mainly due to its undisciplined fiscal policy, reflected in an average annual deficit of almost 9% of GDP over the 1980-97 period. Thus, it was only natural that, she became the third most indebted country in the EU with the increase of the public debt to GDP of over 70 percentage points in 1997 (only Belgium and Italy were then worse), and when it joined the eurozone in 2001, its debt-to-GDP had climbed to around 99% . The situation exacerbated even more after she joined eurozone, as over the 2000-2008 period it surged to 109%, because as a new member she was able to borrow at interest rates that were applicable to a country like Germany. Of course, the onset of the 2008 financial crisis put an end to the lax fiscal policy, as credit conditions tightened drastically.

 A combination of downsizing fiscal policy and collapse of bank credit, created a severe crisis of confidence in the banking sector amidst of a rapidly worsening recessionary conditions. Fearful of banks ’insolvency and Grexit, many savers, including Greek businesses withdrew their bank deposits and transferred their funds to banks abroad. Withdrawals in recent weeks have averaged €200-250m ($218 -273m) per day, and when the talks between the Greek government and its Eurozone and international lenders were on the verge of collapse, they surged to €400m ($436m). The torrent of deposits out of Greece’s paralyzed banking system has forced Prime Minister Tsipras to accept the terms of the nation’s creditors. The banking turmoil has pounded an already feeble economy and lenders demanded urgent injection of new funds, potentially from the European Stability Mechanism bailout fund.

 It is of note that as the BIS data reveals the first bailout of 110 billion euros ($120 b), from the European Union and the International Monetary Fund, agreed in May 2010, was mostly used to save the German, French and some other foreign banks, by reducing their exposure to Greek public-sector debt. Perhaps only close to 17% of the first bailout money were allocated to prop up the Greek financial intermediaries.

 The same was the case in the second bailout, which was arranged by the end of April 2012, after the IMF declaration in June 2011 to the effect that Greek debt was still unsustainable and there was a need for a further injection of between 70 to 104 billion euros. In the second bailout, as part of a private debt restructuring, with an additional 64 billion euros pledges of the EU and the IMF, the Greek debt was reduced by 52% to a level of 107 billion euros, with some creditors assuming about 65% haircut. In an effort to compensate her banks which had suffered disproportionate losses from the restructuring, Greece was allowed to borrow 25 billion euros from the European Financial Stability Facility in April 2012. This recapitalization helped her fragile banks, inflicted with toxic balance sheets, to tap the credit markets again, although they depended completely on emergency liquidity assistance from the ECB, set at 89 billion euros.

The still uncertain deal of today has been vehemently criticized by many as a sign of “The Return of the Ugly German”, as characterized by the former Foreign Minister and Vice Chancellor of Germany Joschka Fischer. According to him”

“For the first time, Germany didn’t want more Europe; it wanted less. Germany’s stance on the night of July 12-13 announced its desire to transform the eurozone from a European project into a kind of sphere of influence. Merkel was forced to choose between Schäuble and France (and Italy).

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Schäuble’s position has thrown into sharp relief the fundamental question of the relationship between Europe’s south and north, his approach threatens to stretch the eurozone to the breaking point. The belief that the euro can be used to bring about the economic “re-education” of Europe’s south will prove a dangerous fallacy – and not just in Greece. As the French and Italians well know, such a view jeopardizes the entire European project, which has been built on diversity and solidarity.”

Germany has been the big winner of European unification, both economically and politically. Just compare Germany’s history in the first and second halves of the twentieth century. Bismarck’s unification of Germany in the nineteenth century occurred at the high-water mark of European nationalism. In German thinking, power became inextricably associated with nationalism and militarism. As a result, unlike France, Great Britain, or the United States, which legitimized their foreign policy in terms of a “civilizing mission,” Germany understood its power in terms of raw military force.

Even the prominent German philosopher Jürgen Habermas, has weighed in the debate in an interview with Guardian criticizing Angela Merkel and arguing:

“I fear that the German government, including its social democratic faction, have gambled away in one night all the political capital that a better Germany had accumulated in half a century.”

The European Economic Community, established by the Treaty of Rome in 1957, from its inception was inherently an “economic” union. Thus, it’s ironical that most critics look at the resolution of crisis as a political challenge and they do not offer an alternative economic solution for Germany to adopt.

In fact, Joschka Fischer’s ascription of *the economic “re-education” of Europe’s south* as the main German motive is a re-hashing of Yanis Varoufakis thesis that:

 Based on months of negotiation, my conviction is that the German finance minister wants Greece to be pushed out of the single currency to put the fear of God into the French and have them accept his model of a disciplinarian eurozone. 

It is economically unrealistic to expect that Germany, Finland, Austria, the Netherlands’ tax payers would be prepared to assume the financial rescue of Portugal, Spain, Italy and France. It is certainly true that these countries have benefited from a lower exchange rate that was made possible by the inclusion of the Southern Europeans in the eurozone, but the union do not have an interstate wealth redistribution mechanism, and in any case the cost of such a hypothetical rescue far outweighs the compounded benefits accrued to the Northern European members . In this light it is clear that the expected deal will not solve anything, and as François Heisbourg, in his article in Financial Times has argued:

Unfortunately, by having avoided what they loathe — debt forgiveness — the Germans may now be hoist with their own petard. Adding billions to Greek debt, enforcing pro-cyclical pension cuts and tax increases in the middle of renewed recession, and positing as in 2011 a €50bn privatisation programme: this is as unlikely to work now as it was in the past. Now it has acquired the formal status of plan B,

Grexit is likely to come back. France would then be faced with an impossible choice: to flow with the German-led tide of Grexit, clearly as a subordinate, or to fight a losing battle to prevent a country from being forced out of the European family. Even Franco-German co-management may not be up to striking a workable compromise. The change behind the scenes is that the Paris-Berlin bond can no longer take strength from the shared project of European integration: France’s 2005 rejection of the proposed EU constitution was a turning point. The relationship has instead become utilitarian and as a result the EU’s days of ever closer union may be at an end.

The deal that is being negotiated will just postpone the reckoning time for current imbalances  for a short while until repaying its creditors becomes an insurmountable undertaking again. Greece won’t get her desired debt relief along the line of a Brady-type rescue package and her creditors will demand more austerity, through fiscal tightening taxes which once again create vicious feedback loops and exacerbate her predicament.

Yet an exit from the eurozone is not a realistic option either, because nobody want to deal with a Drachma that would fluctuate violently in an uncertain political environment where it cannot act as a means of payment, store of value, or any other functions of money. Eurozone is not an optimal currency area, because the economic structure of member countries are not similar. Greece and other Southern Europeans need a much lower exchange rate, which is opposite to Germany’s purchasing power parity requirements manifested by her considerable trade surplus. So why Berlin insists on austerity charade?

The reason, as I have suggested in other fora in the past, is that “this is not a Greek financial crisis but German and French banking crisis.”  While $107 billion dollar Greek  debt to European banking sector appears manageable, even a rather modest money multiplier inflate that amount to a quite frightening level. In fact, since the inception of the euro in 2001, the German, French, and Dutch, banks bought a huge amount of Greek, Portuguese, Spanish and Italian sovereign debts by leveraging their equity capital—this was European version of the US subprime mortgage fiasco. Thus, the balance sheets of these banks, levered up in some cases by forty to one or more, is in a very fragile state. The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

In fact, ECB’s financial stability report, released this May, acknowledges this fragility in a ‘bankspeak’ style :

Monetary policy actions of the ECB, both conventional and unconventional, have clearly reduced stress and fragmentation in euro area sovereign bond markets throughout the last years. In many Member States, long-term bond yields stood at historically low levels in mid-May, and intra-euro area spreads narrowed substantially, also resulting in very low term premia. Clearly, any implied deviation from long-term norms might very well prove to be transitory, so that it is important that investors have sufficient buffers and/or hedges to cope with any prospective normalisation of yields over the years ahead, either from global or from euro area-specific changes in financial risk sentiment.

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Amid some signs of compressed risk premia, the risk of relatively low market liquidity becoming a potential amplifier of stress remains. Broad market liquidity measures for secondary fixed income markets indicate a deterioration of conditions. While bid-ask spreads have fallen considerably from their crisis peaks, turnover ratios show a steady decline across most market segments and the average deal size traded on the largest inter-dealer trading system for euro area government bonds has fallen sharply. Complementing these data-based signals, market intelligence also indicates reduced confidence among large banks with respect to their ability to make markets during periods of stress

(the emphasis are mine) In its identification of the second risk ECB states:

Euro area banks continue to be challenged by relatively weak profitability. Although profitability improved somewhat, on average, in 2014, thanks to lower funding costs and a moderate decline in loan loss provisions, euro area banks continue to lag behind most US peers and European banks outside the euro area. Subdued profitability prevailing over the past few years has been driven by a confluence of factors, including bank-specific characteristics, banking sector structures and cyclical developments. The profitability of euro area banks remains characterised by substantial cross-country heterogeneity. (…) Euro area banks’ profitability will benefit from the ECB’s expanded asset purchase programme as it supports nominal growth, improves asset valuations and effectively rules out debt deflation. These benefits notwithstanding, net interest margins are expected to remain under pressure as a result of the low interest rate environment and flattening yield curves. Bank profitability might therefore be squeezed further if banks cannot compensate for this by increasing loan volumes and/or reducing credit risk.

Thus  it was this vulnerability of the eurozone's banking sector that has motivated Berlin and Paris to create a semblance of deal, no matter how unrealistic it is.  In this regard it is of particular interest that there has been a very clear statement about the need for an speedy resolution of non-performing loans.

A continuing legacy from the sovereign debt crisis is a large and, in some countries, still increasing stock of non-performing loans. Further progress in removing impediments to the supply of bank credit – including faster NPL resolution – is necessary to improve credit conditions, which should be also supported by the ECB’s targeted monetary policy measures. The resolution of systemic NPL problems requires a comprehensive strategy that encompasses necessary improvements in the operational environment and the selection of appropriate resolution strategies. In this respect, it can be concluded that tailored approaches – based on a thorough understanding of the country-specific dimensions of the NPL problem – that are driven as much as possible by the private sector may be most appropriate. The efforts to resolve the stocks of NPLs in parts of the euro area should be carefully designed so as to avoid an undue negative impact on bank capitalisation and to minimise moral hazard.

So is there a solution? As I have repeatedly argued the global financial system is in dire need of a serious coordinated effort to restructure its international flow of funds based on a modern version Purchasing Power Parity criteria, similar to what Gustav Cassel suggested in Brussels conference in the interwar period. Today's extraordinary inflated level of leverages must be deflated in an orderly fashion. While some financial institutions with high leverage ratios may face the risk of insolvency, the risk would be far more manageable in a newly restructured sound international system relative to the existing messy and uncertain situation. We  need an urgent international conference to tackle this very important issue.