Another Bailout Won’t Keep Greece in the Eurozone
The breakup of the euro was once unthinkable. Is it now inevitable?
Facing a deadline of Aug. 20 to buy back 3.2 billion euros in bonds from the European Central Bank, Greek authorities have reportedly reached an agreement with official creditors on a new three-year bailout program. It’s the third in five years and a reminder that the forces that have threatened to break up the euro over the past half-decade remain present. Failure to reach a deal would have cut off the ECB’s lifeline of liquidity for Greek banks, forcing Athens to close its banks again and most likely prepare to exit from the euro.
But this is far from a solution to the problems that plague Greece and the eurozone. Instead, the same painful process that took place a month ago is likely to repeat: The Greek parliament will vote on the agreement and the first batch of conditions for aid, then an extraordinary meeting of eurozone finance ministers will approve the agreement, and then the deal will then be sent for approval to the European Stability Mechanism and the various European governments and parliaments. The aim will be to complete the process in time for the ESM to provide the first tranche of funding for the Greek bond redemptions on Aug. 20. Once again, the situation will appear to be contained — but will the crisis be any less serious?
During the constant negotiations over the past few months, a breakup of the eurozone has at times seemed imminently possible and even likely. Yet the process has distilled two key truths in the heart of the euro’s political contract: The Greek authorities have no democratic mandate to leave the euro, and eurozone institutions — including the ECB — have no veto on eurozone membership. These political factors have contained the overall risk to the markets implied by the Grexit.
This containment has provided a powerful anchor for investor confidence. The risk premiums of Italian, Spanish, and Portuguese government debt versus safer German bonds, which act as a gauge of potential contagion of the crisis across the eurozone, have tightened, too. The euro, now up more than 5 percent from its low this year, continues to defy forecasts for parity with the dollar. This is thanks to the ECB’s quantitative easing program and investors’ faith that a worst-case scenario for Greece will be avoided. The question now is whether the eurozone’s containment strategy is credible beyond the short run — that is, whether it can lead to a viable euro with a stronger economy.
The most likely answer is no. The new bailout fails to address Greece’s chronically toxic debt dynamics. Worsening economic and fiscal fundamentals brought on by this year’s banking crisis and further austerity will render Greek debt, already at 177 percent of gross domestic product, even more unsustainable over time. The program envisages a budget deficit of 0.25 percent of Greek GDP in 2015, while the economy contracts by 2 percent to 3 percent. These are optimistic assumptions. Without any stimulus for demand, the projected budget surpluses of 1.75 percent of GDP in 2017 and 3.5 percent in 2018 will prove unachievable and contractionary, further raising the size of Greece’s debt burden against its deflating economy. This should look familiar to anyone who has been paying attention to Greece for the last five years.
Greece’s metrics of financial health show a similar dichotomy between a short-term sugar rush resulting from temporary liquidity infusion and medium-term economic deterioration. Yields in global markets on Greek two-year government bonds have tumbled by more than half from the highs of 29 percent this year to less than 14 percent on the prospect of more funding from the European Union. However, the cost of borrowing still remains more than 13 percentage points higher than the ECB’s main refinancing rate of 0.05 percent, reflecting Greece’s funding shortfall amid a collapse of bank depositors’ trust, a deflating economy, and frozen access to capital markets.
For Greece and the euro to succeed, that will have to change. The gap between the ECB’s loans to Greek banks and the size of the new bailout is about 40 billion euros, so investors’ trust in Greece will be critical to restoring financial stability. Yet if the banking system can’t be restored to health or the government’s debt can’t be made sustainable, restoring that trust will remain a tall order.
Meanwhile, the toxic combination of double-digit market borrowing costs and deflationary dynamics in the real economy means that Greece remains highly vulnerable to a new political showdown. If this Greek government — or a future one, now that the possibility of another early election is on the table — overplays its hand in eurozone negotiations again or loses control of the domestic political situation, the resulting uncertainty will be hugely damaging to the Greek economy, to the euro, and to global financial markets. This does not appear to be a near-term risk, but it is a chronic one, given growing austerity fatigue among debtor countries and bailout fatigue among creditor countries.
This fatigue raises the possibility that a third unsuccessful EU bailout program for Greece will turn into a road map to the euro’s breakup. It is clear now that the political contract behind the euro is no longer ironclad. After previously defending the irrevocability of the common currency, eurozone leaders — notably including the ECB — are now more open to the possibility of a country exiting the euro. Given the very slim chances of economic success in Greece, this option will stay on the table.
Moreover, despite ECB chief Mario Draghi’s famous promise to do “whatever it takes” to safeguard the euro, the ECB will not always act as a lender of last resort to backstop member states’ banking systems. In essence, the political conditionality attached to EU bailouts gives the ECB a mechanism that can force insolvent countries to drop the euro. Greece’s experience thus demonstrates that national illiquidity and a banking crisis are synonymous with rising risk of a euro breakup. Without much hope that a third bailout will restore Greece’s solvency, it is only a matter of time before the country finds itself back at the euro exit door.
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