What the Greek bailout achieved—and what it didn't

Yesterday, the announcement of a 750 billion euro bailout from the European central bank and the IMF to troubled southern European economies seemed to reassure the markets. The interest rate on Greek government debt fell 5%, the euro gained against the dollar, the spread between German and Spanish bonds shrank, and bank share prices rose by almost 10%. No wonder: 750 billion euros is a lot of money. It’s almost triple the Greek GDP. Bond speculators betting on spiralling southern European debt edged away, acknowledging that the central bank had the money and the will to defend eurozone bond prices.

Unfortunately, $1 trillion doesn’t buy as much reassurance as it used to. Today, the euro is sinking again, and financial markets have opened lower. We should all be glad the European finance ministers who met last weekend had the foresight and courage to put together this unprecedented loan guarantee. Without it, the “PIIGS” nations–Portugal, Italy, Ireland, Greece, and Spain–would have come under enormous attack from speculators. It is not inconceivable the euro could have fallen apart. It didn’t, but the eurozone remains essentially unstable.

Let’s go back to the roots of the crisis. The creation of the eurozone caused the rates for government borrowing across Europe to begin lining up with each other. In the days of the boom, investors were willing to lend to Greece, Italy and Spain at interest rates very close to the Germans. For a while, everybody won: German banks found a market for their excess capital; the PIIGS saw enormous inflows of cash; intra-European exports were the engine of growth for the German economy. But unfortunately, all that money rolling into southern Europe created wage inflation. Because Greek workers are not nearly as productive as Germans, but their wages grew closer to German levels, the cost of production in Greece rose much faster than Greek productivity. The country became feeble in world markets: imports rose, exports declined, the deficit skyrocketed.

There are two ways to pay back foreign debt: borrow more or export more. For much of the decade, the PIIGS could carry on doing the former, and do it cheaply. But with the credit crunch, investors started to realize that maybe Greece wasn’t as creditworthy as Germany. As tax revenues fell and expenses rose, the Green deficit began to look unsustainable, causing bond holders to demand higher interest rates, in turn making the deficit even more precarious. The party was over, the hangover had begun. Now Greece has to pay off its debts the alternative way: by exporting more than it imports and sending the surplus to its northern European bondholders.

But here’s the problem: Greece cannot make exporting pay unless their wages fall 30%. In theory they have two choices: deflation or devaluation. Deflation forces the economy to shrink even more, lowering domestic demand and raising the debt as a proportion of GDP. Devaluation makes Greek products cheaper on world markets without roiling the domestic economy. The pain to the economy and to workers is much less. Of course, being stuck in the euro, Greece cannot devaluate and is stuck with the more arduous solution.

Today, the entire Greek budget deficit is 13.6% of GDP. But their primary budget deficit, which excludes interest payments on debt, is a mere 200 million euros. That is to say, the huge majority of the Greek government’s deficit is interest payments it owes to Northern European lenders. When the primary budget deficit is miniscule compared to interest owed to foreigners, it creates an enormous temptation to default. After all, the main motivation to pay your debts is to maintain access to credit markets. But actually, the Greek government only needs access to those credit markets in order to pay off existing debt. Default or not. Greek wages are going to fall and the Greek economy will be stuck in recession for years to come. And in a democracy, it is hard to win voters on the notion that they will have to sacrifice their own well being in order to pay their debts to foreigners.

In essence, the bailout funded Greek interest payments to German banks, removing much of the temptation to default. It also protected northern banks from the threat of insolvency should they have to mark down their PIIGS debt. As a financier quipped during the Latin American debt crisis back in the 1980s, it is much cheaper to bail out Mexico than to bail out the Bank of America. And importantly, avoiding Greek default lessens the risk of contagion to the other PIIGS economies.

Greece could sink into the Aegean with only moderate effects on the world economy. The great fear, the reason the Germans are digging into their pockets, is that if Greece defaulted, investors would fear the same could happen to the other PIIGS, thus driving up interest rates and making default ever more likely. By establishing this huge credit line and authorising the European Central Bank to buy southern European bonds, the European finance ministers have created a substantial firebreak to prevent default and contagion. However, the essential instability of the European currency zone remains to be addressed. That is why markets have been reassured–but not that much.