The way to end the Greek farce

JUL 12, 2011 10:10 EDT

Reuters 

By Hugo Dixon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The Greek crisis is fast descending into farce. The position of Germany, the euro zone’s main lender, is increasingly absurd. It is adamant that there will be no restructuring of Greek debt — at least, until 2013. And yet it is equally insistent that Athens’ private-sector creditors should contribute up to 30 billion euros to a new, 120 billion euro bailout. That would effectively amount to a half-cocked restructuring.

German Chancellor Angela Merkel’s inconsistencies seem based on her view that a sovereign restructuring won’t happen before 2013 just because she said it won’t. But her conflicting demands are becoming virtually impossible to reconcile. The ratings agencies are threatening to say that Greece has defaulted if there’s so much as a whiff of arm-twisting in the supposed “voluntary” rollover.

While the opinions of the agencies wouldn’t mean that Athens had actually defaulted — they are just opinions, after all — the European Central Bank is acting as if their thumbs-down would open the gates of hell. To show it really means business, the ECB is threatening in such a scenario to pull the plug on Greek banks, something which really would cause havoc. There’s clearly an element of bluffing on the part of the ECB — but it is becoming more transparent by the day, to the point of absurdity.

It’s not too late to end this charade. Athens is now funded until early next year, which buys a little time. Europe should use the summer months to restructure Greek debt properly and put in place measures to minimize contagion elsewhere.

A sensible Greek restructuring would probably involve slashing its debts by around half — provided it sticks with a medium-term program to cut its fiscal deficit, privatize assets and reform its corrupt public sector. Athens wouldn’t just get debt relief. It would also receive funding from the euro zone and the International Monetary Fund, albeit not as much as currently contemplated because private-sector creditors would be fully, and not partially bailed in.

To minimize contagion, two things would be needed. First, many European banks would have to be stuffed with much more capital than is likely to be contemplated under the stress tests that Europe is just about to publish. The key is to ensure that markets have confidence in banks even after they have taken a hit from a Greek default. Second, the ECB’s role as a lender of last resort to weak banks in weak countries would need to be reinforced.

All this would be costly. Governments would have to stand ready to inject equity into banks which the market was not willing to finance — in much the same way that the United States did when it conducted its stress tests of American banks in 2009.  Some banks would end up being partly nationalized. The euro zone collectively would have to provide cash to Athens to recapitalize its banks, which are up to their eyeballs in their own government’s debt. The European Financial Stability Facility, the region’s bailout fund, might even need to have its rules modified so it could provide a line of credit to Spain given that Madrid has been too slow to assemble a war chest to bail out its savings banks, which are awash with toxic property assets.

The euro zone would also have to provide an indemnity to the ECB to persuade it to act as lender of last resort to weak banks. This could be modeled on the way the UK guaranteed potential losses by the Bank of England when it provided a special liquidity scheme to British banks to help them finance their illiquid mortgage assets after the credit crunch.

But these costs would at least partly be paid for by the fact that the purely Greek bailout, if it happened as soon as possible, would be smaller. There would also be a huge benefit in getting an orderly default over and done with, rather than dragging out a process that is debilitating parts of the euro zone economy and has the potential to turn into a rout.

Such a program would require a lot of people to eat their words — not just Merkel but pretty much every other euro zone leader. Still, with market jitters now affecting Italy, which really is too big to bail, it is risky to prolong this opera buffa any longer.