It was a mistake to bail out Greece in 2011. Better to default on debt held by private creditors than leave European governments in the lurch.
Europe’s governments and the IMF made an enormous mistake in bailing out Greece’s private creditors in 2010 and then overseeing a botched debt restructuring in 2012. In turn, the Greek governments of this era made the mistake of accepting official loans to pay off private creditors, perhaps not realising they were jumping out of the frying pan straight into the fire. Now the Greeks are learning that defaulting on private creditors is one thing (not so hard it turns out, once you’ve got Lee Buchheit in your corner) but defaulting on governments of rich European countries is quite something else.
The No-Bailout Clause
A couple of years ago, when I was writing this article, I reviewed many papers on prospects for the euro written by economists in the 1990s. I was struck by the consensus that the fiscal limitations of the Stability and Growth Pact would generally be honoured, that euro members that got into fiscal troubles would not be bailed out by other countries and this would lead to sovereign defaults when countries did get into fiscal problems.
By and large, the policy heavyweights of the day, such as Rudi Dornbusch, believed there was a “categorical no-bailout injunction.” As such, it was expected that markets would understand that European governments were more likely to default once their devaluation option was taken away and that financial markets would price the sovereign debt of countries differently depending on the health of their public finances.
Yields on sovereign debt across all euro area members — which had previously differed substantially — converged within a narrow band and remained this way until 2009.
Economists also got it wrong about the “categorical no bailout injunction.” It turned out that no such clause really existed in the European Treaty. The relevant article (No. 125 of the current treaty) merely stated that the Union and its member states “shall not be liable for or assume the commitments” of other countries. This isn’t really how bailouts work: Those doing the bailout rarely announce “we’re taking over this country’s debts.” Instead, they provide loans to the government that is in trouble and these loans allow this country to honouring its existing loan commitments.
By early 2010, it became increasingly clear that Steinbrueck’s viewpoint would prevail and that a Greek sovereign default at this point was not something the euro area’s leaders would countenance. By March 25, 2010 loans to Greece from the rest of the euro area and the IMF were announced and by May a fully-formed bailout fund for the euro area, the European Financial Stability Facility (EFSF), had been put in place.
Despite Greece’s completely unsustainable debt position, private creditors continued to be repaid over two years with these debts replaced by loans from European countries and the IMF. By the time Greece’s debt to the private sector was restructured in 2012, its economy was in ruins and the remaining unrestructured debts to the “official sector” were clearly unsustainable.
Why Bail Out Greece in 2010? European Banks?
So why were Europe’s politicians so keen to provide massive loans to Greece in 2010? One answer that comes up time and again is that European governments were using the loans to Greece as a way to protect German and French banks that had built up large exposures to Greek sovereign debt. In the febrile anti-banker environment of 2010, a programme advertised as “European solidarity” was more likely to work politically than another round of bank bailouts after a Greek default.
The ECB, in particular, played a crucial rule in presenting a Greek default as a potential disaster for the euro area and delaying the decision to allow such a default. Via their highly discretionary ability to cut off funds to the Greek banking system, the ECB have had a huge influence on the course of events.
Over 2010 to 2012, members of the ECB Executive Board, such as Lorenzo Bini Smaghi regularly gave speeches depicting the depicting a potential Greek default as provoking “an economic meltdown”.
In the event, Greece did default and it was declared a credit event. And the world simply didn’t care. There was no financial meltdown. The ECB’s analysis was completely wrong and its influence on the events in Greece was utterly negative from 2010 to 2012. Time well tell whether 2015’s ECB does any better.
My favourite theory, however, as to why European governments bailed out Greece is political hubris. European politicians were so sure the euro was a fantastic political success that a nasty event like a default was simply unthinkable for a euro area member state.
By March 2010, Juncker’s rhetoric had risen to the level of explicit threats of restrictions on financial markets:
We have to strengthen the primacy of politics. We have to be able to stop financial markets. We have instruments of torture in the basement. We will display them if it becomes necessary.
At a distance of five years, this is obviously complete rubbish but this was what the official voice of European economic policy was saying at the time.
But, But, But the Greeks
I know many people will react to this piece by arguing that reckless, feckless Greeks are the real villains, cooking books and refusing to reform. Many will focus their anger on Syriza and point out that their election promises were undeliverable and ignored that the official creditors were never likely to be in the mood to offer significant debt write-downs or to get over their long-standing urge to micro-manage the Greek economy.
But these arguments focus on the smaller specific tactical issues of how the Greek debt problem evolved and how the the current negotiations are going. They ignore the fact that we have only arrived at this juncture because of the utterly flawed lending decisions of Europe’s governments.
While it is too much to expect these governments to put in place a sensible programme of the type proposed by former IMF official, Ashoka Mody, European citizens should expect their politicians to acknowledge there past mistakes and to accept that flawed lending decisions imply financial costs.
Nobody knows how a euro exit would work or how it would affect other member states. But it will mean, for sure, that the euro is not a “fixed and irrevocable” currency union. And it will mean that there are unwritten rules that link membership of the euro with willingness to pay back official loans.
Those who actually believe in European monetary union need to understand on Monday that pushing the Greek government further than their current position will generate infinitesimally small financial gains for European citizens while risking a Greek exit threatens unquantifiably large potential costs.