Europe struggles with bad choices
By Mohamed El-Erian
The opinions expressed are his own.
Very few of us like to be confronted with unpleasant choices. If we are, we will tend to delay a decision. And if forced to make one, we will likely opt for the choice that, in our minds at least, seems less disruptive upfront — even if we know it is likely to involve discomfort down the road.
This simple human analogy is critical in understanding why Europe’s increasingly ugly debt crisis refuses to go away. It sheds light on the choices made up to now; and it speaks to why an increasingly incoherent policy response will likely end up in tears for Greece and potentially other European economies and institutions.
Let us wind the clock back to just over a year ago when Europe first bailed out Greece, a country no longer able to pay its bills. Together with two monetary institutions — the European Central Bank and the International Monetary Fund — European politicians faced unpleasant choices and had to respond. But rather than decisively addressing the problem, they essentially opted to kick the can down the road.
There were, and still are two main reasons for Greece’s predicament: The country borrowed way too much; and it failed to grow its economy on a sustained basis. This lethal combination was amplified by weak public administration.
Yet the rescue of Greece involved making new loans to the country and was asking for a very ambitious fiscal adjustment effort. Neither the size of the debt nor growth reinvigoration were properly addressed.
I suspect this choice was not driven by a strong conviction that the approach would work. Rather, decision makers feared the complexity of the alternative which involved opting for a pre-emptive, and hopefully orderly debt restructuring, and placing much greater emphasis on structural reforms.
A year later, Greece is still in the financial intensive care unit, and needs renewed urgent attention by the “troika” of doctors — from the European Commission, ECB and the IMF.
Regrettably, the country’s condition is even more serious now, with every single one of its vitals worse than projected by these same doctors a year ago.
The economy has contracted by more than programmed: unemployment is higher, debt and deficit dynamics are worse and, with market risks measures of spreads at even more alarming levels, the country is further away from restoring access to normal capital market financing.
Understandably, the Greek government is under intense pressure at home from a population that is being asked to sacrifice tremendously but sees virtually no improvements on the horizon. Coordination among lenders is becoming more difficult as two related concerns fuel ever-growing bickering: what has happened to all the money that has already been disbursed? And, why are so many dubious liabilities being transferred to taxpayers from private creditors, who were paid an interest rate premium to take an informed risk?
No wonder Europe’s approach to its debt crisis is losing credibility. In the process, the institutional integrity of some key institutions is being undermined.
This is particularly true for the ECB which now finds its balance sheet saddled with billions of Euros of Greek bonds. Some were purchased in a failed attempt to counter the surge in Greece’s risk spreads; others are related to repo operations that have kept afloat an essentially bankrupt Greek banking system.
When you think of it, none of this should really come as a surprise to Europe’s decision makers. At its root, the approach to solving Greece’s excessive debt problem was to pile new debt on top of old debt; and the accompanying medication served more to reduce growth than improve the structural drivers of a sustained economy expansion.
Despite this obvious diagnosis, the doctors are essentially at it again; and the patient, already weakened, is forced to commit to yet greater sacrifices. Thus, Greece will get more debt-creating financing in exchange for even larger fiscal austerity.
However, it is not entirely all déjà vu. It seems that there will be two tweaks in the days ahead.
The first, involving a more structured privatization initiative, will look good on paper but is unlikely to deliver much. The second is more promising, if pursued properly. It entails “convincing” private creditors to renew their maturing loans to Greece rather than exit completely.
Notwithstanding these modifications, I fear that this new rescue of Greece will, again, only kick the can down the road. It will not materially improve Greece’s solvency outlook; nor will it do much to promote growth and employment. What it will do is fuel more social unrest in Greece and intensify tensions within the official creditor community.
There is one silver lining here. In again opting for the seemingly easier but ultimately unsustainable choice, the troika is giving other potentially vulnerable parts of Europe more time to get their house in order — thereby reducing contagion risk.
Some countries, like Spain, are taking advantage of this window. Under the guidance of the central bank, the savings banks (“cajas”) are getting serious about strengthening their capital buffers. Such capital raising should be pursued aggressively by more banks across the Euro-zone. And, hopefully, the ECB is discussing how to navigate its weakened balance sheet through the minefield of an inevitable Greek debt restructuring.
So is this tradeoff — persisting with a costly approach for Greece in order to buy time for the rest of Europe — worth it? As much as I would like to say yes, I worry that the answer is likely to be no.
First, Greece is not the only country in this highly unfortunate situation. Ireland and Portugal face similar debt and growth challenges, though somewhat less severe. Given that the troika is applying the same remedy there too, the overall cost of this unsustainable approach is even larger.
Second, the money being transferred to private creditors could be used more efficiently in safeguarding the European system directly, thus reducing vulnerability to contagion risk.
Finally, the viability of simply kicking the can down the road is undermined by growing cooperation challenges — between Greece and the troika, and within each group in this tragedy.
As Europe finalizes its new bailout of Greece over the next few days, it would be well advised to keep these considerations in mind. It is not too late to correct the course, and opt for a choice that is unpleasant upfront but offers a greater chance of success over the longer term.
Photos, top to bottom: Protesters raise arms in front of the Greek parliament during a rally against austerity economic measures and corruption in Athens’ Constitution (Syntagma) square June 5, 2011. The protest, on its twelfth day, was organized through a Facebook group called “The Indignant”. REUTERS/Pascal Rossignol; Employees of the Hellenic Postbank push a mock money box during a rally against government’s privatisation plans in Athens June 2, 2011. Greece wants to sell its entire 34 percent stake in the lender by the end of the year as part of a goal to raise 50 billion euros by 2015 to pay down its debt mountain. REUTERS/Yiorgos Karahalis