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Don’t lend to your euro friends

Aug 09,2015 - Last updated at Aug 09,2015

After months of games and brinkmanship, and only a week after Greek voters rejected the conditions for a 7.5 billion-euro ($8.2 billion) rescue package, the end came swiftly. The eurozone’s political leaders agreed to start negotiations on a much larger package, worth 86 billion euros, almost half of Greece’s GDP. Unfortunately, the deal reveals Europe’s apparent determination to re-enact the same tragedy in the future.

Over the past five years, a whopping 344 billion euros has flowed from official creditors like the European Central Bank and the International Monetary Fund into the coffers of the Greek government and the country’s commercial banks. But after six months of near-futile negotiations, exhaustion had set in and holidays were beckoning; so the actual conditions for a new Greek rescue were given short shrift. Although the European Financial Stability Facility had officially declared Greece bankrupt on July 3, the eurozone’s leaders kicked the insolvency can down the road yet again.

The latest agreement did halt, or at least interrupt, the eurozone’s biggest crisis to date, culminating in an unprecedented period of antipathy, opprobrium, humiliation, pestering, and blackmail within Europe. Indeed, Greece came within a hair’s breadth of leaving the eurozone.

Former Greek Finance Minister Yanis Varoufakis revealed that after taking office, he assembled a group, with the consent of Prime Minister Alexis Tsipras, that met in secret to prepare the introduction of a parallel currency and the takeover of Greece’s central bank — effectively an exit (or “Grexit”) from the eurozone. Germany’s government also was ready to accept what appeared to be the inevitable. Had French President François Hollande not advised Greece behind German Chancellor Angela Merkel’s back about how to negotiate, events could have taken an
entirely different course.

The bitter dispute within the Eurogroup (comprising the eurozone countries’ finance ministers) not only strained relations among the monetary union’s members, but also fuelled tensions within national governments. Many European leaders are still smarting and licking their wounds. But this should also be a time for them to reflect on what happened and why.

The spat resulted from an attempt to set politics above the laws of economics. The dogma of European policy makers’ infallibility and the irrevocability of every step toward integration collided with reality.

Europe will face many such conflicts in the future if it continues to apply the same approach to its debt problems that it used in the Greek case. The fundamental error occurred in April and May 2010, when official lenders — in the form of other eurozone member states — replaced Greece’s private creditors.

That arrangement was proposed by then-ECB president Jean-Claude Trichet, in clear breach of the Maastricht Treaty’s no-bailout rule, which had been Germany’s fundamental condition for giving up the Deutschmark. But French President Nicolas Sarkozy threatened to leave the euro (as Spain’s former prime minister, José Luis Rodríguez Zapatero, later revealed to the newspaper El País) unless Germany signed on to the bailout agreement. Christine Lagarde, the French finance minister at the time, said, “We violated all the rules because we wanted to close ranks and really rescue the eurozone.”

The rules were indeed violated, but whether the bailout decision rescued the euro remains to be seen. It certainly rescued many commercial banks, whose exposure toward the Greek state was substantial by the first quarter of 2010. Greek banks had lent most to the Greek government (29 billion euros), followed by French banks (20 billion euros), German banks (17 billion euros), and US banks (4 billion euros).

The bailout also rescued the ECB, insofar as the fiscal credit replaced some of the bank’s Target credit that had built up from the beginning of 2008. At that time, the Greek economy confronted a sudden stop of private capital inflows, and the Greek central bank financed the country’s entire current-account deficit with additional refinancing credit from its local electronic printing press.

But rescuing banks is not the same as rescuing the euro. Moreover, rescuing the euro is not the same as rescuing the European project.

The bailout decision in 2010 transformed a normal commercial dispute between creditors and debtors — one that always arises when debtors fail to repay — into a dispute among sovereign states. This whipped up animosity among Europe’s peoples and provided ammunition for radical parties of all stripes, severely damaging the European integration process.

Without the socialisation of debt provided by the rescue packages, Varoufakis, or whoever led Greece’s finance ministry, would have had to declare insolvency and then confront private creditors from a variety of countries. These countries’ governments would then have felt compelled to rescue tottering banks with their taxpayers’ money.

To be sure, rescuing local banks would have been no walk in the park. But it would have spared Europe the spectacle of its member states’ governments baring their teeth at one another. In 2008, Germany rescued Hypo Real Estate, and in 2011 Belgium, France, and Luxembourg bailed out Dexia Bank. As these cases suggest, cleaning one’s own porch could have been done without much of a fuss, or at least without stoking international tension.

Banks and their media enablers always predict disaster when write-offs loom. Trembling politicians then usually acquiesce and put their taxpayers on the hook. But the more than 180 sovereign defaults that have occurred since 1945 did not push the defaulters off a cliff. Instead, as a rule, they gained a fresh start. In fact, the dangers that are now facing Europe as a result of socialising debts are far greater than those posed by a mere potential financial crisis.

The lesson to be drawn from the Greek debacle is that the eurozone must develop sovereign insolvency procedures as quickly as possible, thereby preventing other sovereigns from becoming creditors through debt mutualisation. If the European Union’s national governments want to help one another in a crisis, they should unilaterally provide humanitarian aid, without conditionality and without redemption. If you lend to your friend, he will no longer be your friend. Unless that wisdom is heeded, it will be impossible to hold Europe together.


The writer, professor of economics and public finance at the University of Munich, is president of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author, most recently, of The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs. ©Project Syndicate, 2015. 

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