Bailouts won't change a thing...

Whilst most people are increasingly likely to greet news about Greece with a sense of fatigue, the main battle lines appear to criss-cross political camps. The arguments have been rehearsed endlessly so I spare you another repeat. However, there is one aspect that receives less attention. It's the ability of the Greek government to reform as opposed to its willingness to do so.

Much of the discussion hinges on whether Greece can get the breathing space through another bailout (or a long term debt relief) to reform its economy and become competitive in the world markets again. This assumes however that the Greek government has the wherewithal to actually carry out reforms at this stage. It seems to me that this is a huge assumption to make given the parlous state of its tax system and the traditionally low levels of administrative governance in the country. So, despite all talk about the pros and cons of bailouts, even if Greece would be afforded some space and time, it is unlikely to emerge any time soon as the all new and shiny South European twin sister of Germany.

This aspect shifts the perspective from what the Greek government is willing to do (triggering nasty discussions about blame) to what it can and can not do, prompting a realistic calculations of the chances to reform. It is that realism that should guide politicians on Monday what to do about Greece, rather than indulging in fantasy scenarios.

The blackmailers

Greece's financial situation is becoming more precarious by the day. Paradoxically, it is not its debt that is weighing Greece down nor the greed of its lenders, but it is the lack of trust by its own population that is making life harder by the day. Greeks are still withdrawing millions of Euros every day from their bank accounts, clearly anticipating that this will all end in tears, i.e. the Greek exit from the Euro.

The sad aspect of this Greek saga is that it was entirely preventable. Greece's debt burden was heavy yet entirely manageable at the time of the election, and the budget ran a first initial surplus. The economy showed some signs of recovery and investments picked up. All that has now stalled due to the insecurity created by the zig zag course of the new government.

So what's the case for the strategy pursued by the Greek government? Let's look back at the last six weeks. Starting with the election, the Greek government had a very strong lever at their disposal. Germany as well as all other main players signalled that they would make sure that Greece remained within the Euro. This was a solid foundation from which to build within the Euro zone a coalition around change for growth and investment. At about the same time, the recently appointed Commission President Juncker announced that he was working on something similar which chimed with the intentions of the Greek government to move from austerity to investment for growth, a (now approved) 350 billion Euro programme.

Yet, within two weeks after the elections, the Greek government managed to antagonise not just its main lender (Germany and the IMF) but also its smaller European partners, such as Slovenia and Slovakia, who notably contributed millions of Euros to the Greek bailout programme despite being much poorer than Greece. Talk by the Prime Minister Tsipras and his thin-skinned Finance Minister Varoufakis about Greece's entitlement to other countries taxes ensured that they lost all good will by their European counterparts. Eventually, the Greek government had to climb down and accept a four month extension of the existing bailout programme to the old conditions. This can only be called a phenomenal failure of policy on the part of the Greek government given that they actually had a strong negotiating position at the start.

Why did this go so horribly wrong for the Greek government? The main reason appears to lie in their inability to differentiate between electoral campaigning and negotiating with European partners. Both Tsipras and Varoufakis appeared to believe that their electoral campaign rhetoric would bear just as much weight in negotiations with their European partners as it had with the Greek electorate. Their maximalist demand (access to taxpayer's money of other countries without any budgetary control) may have made sense within the domestic national debate, but its logic fell apart quickly when articulated within European institutions. Confronted with this failure to get their way, Tsipras and Varoufakis resorted to blackmail, indicating that they would violate ECB rules if their European partners would not meet their demands.

In a way, this strategy ensured that Euro zone members are now seriously thinking whether a Greek exit from the Euro would indeed weaken the Euro, or whether in fact it may strengthen the currency. Which is exactly where the Greek government does not want to be in the larger scheme of things. Once their main negotiating asset, the unwillingness of their partners to allow a Grexit is gone, they will have no levers for negotiating further debt relief. The Greek negotiating tactic resembled a high wire act which they embarked on with several heavy suitcases stuffed with maximalist demands instead of travelling the rope as light as possible. This whole episode may soon feature in university handbooks on policy making as a prime example of poor strategy. Once safely back in his university post, Professor Varoufakis may be able to read up on it.

It's the rules, stupid

As the drama of the Greek show down moves to the second stage, observers and commentators cast around for interpretations. Austere Germans versus profligate Greeks is one of the popular topoi, and so is responsible versus irresponsible governments. Yet, what is often forgotten is the main protagonist: the Euro itself.

The Euro as a common currency originated in the German re-unification and the desire of France's president Mitterrand to have the German Mark. And it was Chancellor Kohl's bargaining chip in the negotiations to reconcile France with the fact of a resurgent German economic powerhouse. Attached to the deal was the so-called fiscal stability pact which was promptly broken by Germany and France. The former failed to stick to the pact because national finances spiralled out of control in the wake of re-unification and the costs of upgrading East German infrastructure to West German standards. The latter, France, failed to keep its budget under control because ... well, because they was little incentive to do so. 

To be clear, all this happened well before the financial crash of 2008. In fact, it was Chancellor Schroeder, a social democrat, who, in 2004 embarked on a fundamental reform of employment regulations which set Germany on a path to fiscal rectitude. This first drama of the Euro stability pact is often forgotten in public debate today. But it was a key experience for German politicians. Embarrassed and shamed into a climbdown on the rules they had formulated themselves, they learned a simple but important lesson. A currency is only stable if the budgetary rules are enforced that come with it. 

That's the main reason why German politicians (Social Democrats and Christian Democrats alike) are playing hardball with Greece today. It has little to do with fears of inflation Weimar style. Nor is it to do with spite or resenting the Greeks their living standards financed by debt. Rather, it is the realisation that enforcing the rules strengthens the currency rather than weakens it. Seen this way, a Greek exit (though highly undesirable for everyone involved) may actually send a strong signal to the markets: we are determined to enforce the Euro rules, to safeguard the currency's stability. 

The French President on a flight of fancy

Francois Hollande, the French President, has declared the Euro crisis over a couple of days ago. His announcement comes at a time of unprecedented unemployment in Spain, Italy and his own country, as well as at exactly the moment when Mario Draghi's promise to 'do what it takes to save the Euro' (i.e. buy unlimited bonds from Italy, France or Spain) is under scrutiny at the Constitutional Court in Germany.

Apart from the odd timing of Hollande's announcement, and it's peculiar echo of the sun king diktating the will of the markets, it is likely to be more in the category of wishful thinking. The Euro crisis is fundamentally a crisis of budget deficits and national debts, bloated by enormous bail outs for troubled banking industry in the wake of the financial crisis. For France, and for the socialist president, this crisis is however mainly one of austerity and its effects. Or so he thinks. 

The recent strike of the French air traffic controllers, grounding in one fell swoop half of Europe's air traffic for three days, demonstrates what this is really about: a largely unreformed public service, a highly fragmented trade union movement in France which makes effective negotiations of labour disputes difficult to say the least, and the unwillingness or inability of the French President to take on the problems he was elected to tackle. So, Hollande is looking for an easy way out. Declaring the Euro crisis over, so he believes, will open up the coffers of the European Central Bank for the French government. If the Euro is sorted, France can continue to spend, ever onwards with its profligate ways. 

Observers are agreed in disagreeing with Hollande. What France needs are reforms, not higher wages for less and less work. The Commission President Barroso recently put it simply: France is loosing its competitiveness rapidly compared to Spain and Portugal (of all countries!) where radical reforms have begun to turn the ship around. It's about time Hollande understands that Europe wont wait for France, Euro crisis solved or not.

Why the Euro is still stable

When Britain dropped out of the ERM, some people got very rich. George Soros was one of those who  bet against the pound remaining in the ERM and the windfall from the decision of the British government (reportedly more than 1 billion dollars) made him a rich man for the rest of his life. The current crisis of the Euro should equally see plenty of hedge funds betting against the Euro but nothing similar to the ERM disaster has happened so far. The question is why is no one betting against the Euro? The answer is an interesting one and reveals why the Euro is not dead by any measure.

First, the Euro has remained stable in terms of currency fluctuations. The reason is that, while capital flight from Greece, Spain and Italy has certainly occurred, the surplus money has mainly been invested in German bonds, which balances out the Euro capital flows across the currency zone. Second, Spain and Italy have actually imposed bans on short-selling which prevents hedge funds to bet against Spanish and Italian bonds. With Greece the case is slightly different. Although credit default swaps are still in place, any heavy betting against them may trigger a large scale default of the country which in effect wipes out any chance of gaining a profit in the process. So there are limits to the profit you can make in a highly speculative market. Traders know that and hence stay away from an overheated Greek bond market.

But a look at some of the capital transfers within the Euro zone also indicate why the currency is still stable. Although there are some serious divisions between those countries that lose capital there are also winners such as Germany. In order to balance the loan commitments between individual national central banks and the ECB, the German Bundesbank has lend back much of the capital it gained through the bond market to the ECB. According to the New York Times, the Bundesbank lend the ECB over a 12 month period more than 730 billion euros up till June this year, double the amount it led in the previous 12 month period. So, while the Euro is internally riven with divisions, the overall capital transfer balance ensures that the Euro itself has not come under the onslaught of traders betting against a Euro collapse. However, as Moody has pointed out recently in its report on Germany's credit rating, Germany's ability to counteract some of the effects of this capital flight is not unlimited. So the picture can change very quickly and we may still see some people getting very rich indeed.

Deja vu in France

Francois Hollande (left) and Nicolas Sarkozy (right)
Picture courtesy of  BBC

There you have it: Francois Hollande and Nicolas Sarkozy, the candidates of the main centre-left and centre-right, are through to the second round of the French presidential elections. While Holland, the candidate for the Socialist Party does not exactly promise milk and honey to his French compatriots, he does want to roll back the modest reforms put in place under Sarkozy. In particular, the rise of the pension age from 60 to 62 (in Germany the pension age is 67) attracted the ire of some of the French electorate. 

We have been here before. The last Socialist President in France, Francois Mitterrand, equally promised a lot. After being elected he dramatically expanded the state sector to reduce unemployment, yet found that there was little money left in the state coffers and had to back-paddle very quickly to avert economic disaster. 

There is a significant difference between Mitterrand and Hollande however. As Mitterrand promised to commit more public money to correct the ills of the French economy, he only gambled the money of the French. Now France has the Euro and any public spending commitments that cannot be met from taxation and public borrowing within the rules of the austerity pact signed with other Euro member states, will have to come from somewhere else. 

Hollande thinks he has solved the dilemma. He announced that he wants to renegotiate the recently signed Euro stability pact to allow the European Central Bank to lend directly to the French government. In other words, he wants to be able to tap into the cheap money underwritten by a more competitive German economy and German tax payers while delaying or reversing the much needed economic reforms in France. 

Whatever he thinks he can achieve by increasing the already enormous mountain of debt of the French state, the past should be a reliable benchmark of his chances of success. Mitterand’s actions triggered a rocketing inflation that threatened to spiral out of control and throw the French population into a deep economic crisis. He reversed course within a year. It seems that Hollande has failed the test of any responsible politician even before he wins his right to move into the Elysee Palace: learn from past mistakes. 

Why the Euro is not dead (yet)

As with so many things in life, your own experience gives shape to what you know and what you see, yet often only at the exclusion of other viewpoints. So it is with the British debate on the Euro. The currency that celebrates its decennial this January is thought to be doomed by most British observers. For them, the only question worth answering is when the final collapse will happen and whether or not it will drag the entire European project with it. 

You only have to take a flight to Berlin, as I did over the Christmas holidays, and pick up some German papers to understand how alien this view is to German opinion-makers. Believe it or not, German newspapers and journals thought they had genuine reason to celebrate the birth of the common European currency ten years ago. 

And, contrary to British public opinion, they might just have cause for celebration. Despite all nay-sayers, the Euro is for all intents and purposes actually doing very well. Especially so for German purposes one might add. In terms of stability, the Euro is more stable than the Deutschmark, with ten year inflationary rates of less than 2% (the rate for the Deutschmark was more than 5%). Even more importantly for the export orientated industry in Germany, it remains a comparatively weak currency which boost German growth to an extent not experienced since the 1970s. 

It is these undoubted advantages of the currency to the German economy that many British commentators fail to factor into their calculations of impending gloom. The Euro is not only a political project, it is also one that has produced unprecedented growth rates in Germany at a time of shrinking manufacturing output for the rest of Europe and struggling industries across the Western world in areas where Chinese producers offer more competitive conditions. 

Whether the critics of the Euro like it or not, it is most likely to survive as long as the German people take a rational view of the enormous benefits that the common currency has brought. And for those who harbour some nostalgia for the Deutschmark, help is afoot: there are still about 13 billion Deutschmark in circulation in Germany. If you like you can even pay at high street shops in Berlin with the old currency which is still legal tender. 

Would Greek default bring Greek prosperity?

There have been few things that arouse people's feelings like the impending Greek default. The airwaves and the print media are full of informed and some less informed opinions and debates. Essentially there are two camps at the moment: those who feel that the austerity imposed on Greece is unjustified and creates unacceptable hardship for the Greek population and those who think that Greece has to pay for its sins.

I have advocated the latter but, I have to admit, there is little comfort in such a view. The Guardian comments pages carried an articulation of the first view, you can read it here http://www.guardian.co.uk/commentisfree/2011/sep/19/greece-must-default-and-quit-euro

The author essentially advocates a default of Greece and the re-introduction of the drachma in quick succession. He believes this will allow the government to de-value the currency and postpone the austerity programme, hence producing less pain for the Greek population.

The fascinating aspect of this view is that it operates with some of the conventional market-supply side frameworks it attacks. De-valuation is believed to bring about a quick recovery of the Greek economy, an increase in Greek exports and hence a significant rise in tax revenue.

This view is, strangely enough, as short sighted as all the IMF programmes of the 1990s were supposed to be. Yet, default is a favourite view of the opponents of reforms and austerity. Why?

There are several simplistic assumptions that would work against a successful recovery if Greece defaults and leaves the Euro.

First, a default will not only be bad for Greek credit in the future, but also for the rest of the European banking system, which, whether they like it or not, is the one that will have to lend the money to Greece once it leaves the Euro. A banking crisis will make quick lending on favourable terms and interests rates to the Greek economy or her government unlikely.

Second, a recovery of the Greek economy will depend on competitive industries and having goods to export. Greece has neither. It is essentially, as many observers commented, still a closed economy, importing goods from the Eurozone (on account of demand through high salaries in the bloated public sector) but able to export little since it has only a slender industrial basis. Being competitive in the world markets, in turn, would depend on attracting investment which, again, cannot come from Government since it is flat out broke, so requires the banks in the Eurozone to chip in. This is highly unlikely given the prior default.

Third, the default will remove any incentive to reform the tax system and to shrink the bloated public sector with massive pension liabilities. So, even after a default, the government will still face an enormous annual expenditure which will drive up inflation.

Last but not least, Greeks are saying they are hurting now since they cannot buy goods anymore as their wages are decreasing. However, things would be even worse after a default and the re-introduction of the Drachma. Since most goods are IMPORTED from the Eurozone, leaving the Euro will make these goods prohibitively expensive. The Drachma will not buy much in the way of IKEA furniture or French perfume. What will be left to buy are goods manufactured in Greece, of which there aren't many. Hence the Greek population will experience a far more serious decline of their quality of life after leaving the Euro than now.

The simplistic equation: leaving the Euro + devaluation = less austerity fails to recognise that Greece in future still needs an enormous amount of steady investment to improve its industries. Any short term relief from the postponement of the austerity and reform programmes are likely to backfire.

To have any chance of overcoming its problems, Greece needs to stay in the Euro and swallow the bitter pill of giving up its fiscal independence. This is a small price to pay for the chronic mismanagement, budget falsification and billions of Euros they received.