The ECB's Three Mistakes in the Greek Debt Crisis

By now just about everybody agrees that the European bailout of Greece has failed: The debt will have to be restructured. As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.

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There is plenty of blame to go around. But three big mistakes can be attributed to the European leadership. This includes the European Central Bank - surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.

Mistake number 1 was the decision in 2000 to admit Greece in the first place. The country was an outlier, geographically and economically. It did not come close to meeting the Maastricht Criteria, particularly the 3 % ceiling on the budget deficit as a share of GDP. No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.

The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007. Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany. Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period. And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators. But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.

The third mistake was the failure to send Greece to the IMF early in the crisis, before Greek interest rates went to 600 basis points (see graph). By January 2010 the need to go to the Fund should have been clear. Rather than going into shock, leaders in Frankfurt and Brussels could have welcomed the Greek crisis as a useful opportunity to establish a precedent for the long-term life of the euro. The idea that a debt problem of this sort would eventually arise somewhere in euroland cannot have come as a surprise. After all, why had the architects of the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability & Growth Pact (1997) written them in the first place? Skeptical German taxpayers believed that, before the project was done, they would be asked to bail out some spendthrift Mediterranean country. European elites adopted the fiscal rules precisely to combat these fears.

When the rules failed and the crisis came, the leaders should have thanked their lucky stars that the first test case had arisen in a country that met two characteristics admirably:
(i) The Greek government had broken the rules so egregiously and so frequently that one could with a clear conscience judge that a firm stand was merited. The only alternative was to risk establishing the precedent that even profligate governments can expect ultimately to be bailed out, with all the moral hazard headaches that precedent implies. (ii) The Greek economy was small enough to make it feasible for Europe to come up with the funds necessary to insulate others who were vulnerable to contagion but not as blameworthy: banks that hold Greek debt and governments such as Ireland that had tried to follow responsible policies in the period before the global financial crisis.

European leaders also should have thanked their stars that the IMF exists. Instead of acting as if such a crisis had never been seen before, they should have realized that imposing policy conditionality in rescue loan packages is precisely the IMF’s job. International politics is less likely to prevent the Fund from enforcing painful fiscal retrenchment and other difficult conditions than it is among regional neighbors or other political allies. Europe is no different in this respect than Latin America or Asia.

But the reaction of leaders in both Frankfurt and Brussels was that going to the Fund was unthinkable, that this was a problem to be settled within Europe. They chose to play for time instead, to treat insolvency as illiquidity. Against all evidence — despite a decade of SGP violations — they still wish to believe that they can impose fiscal discipline on member states. Despite two decades in which citizens of Germany and other European countries have expressed clearly that they do not share their leaders’ enthusiasm for Economic and Monetary Union, the latter apparently still wish to believe that further progress to political and fiscal union is possible. The emu has long since become an ostrich, burying its head in the sand.

It turned out that the German taxpayers had been right all along. How, in light of that democratic deficit, can anyone think that Europe is ready for a transfer union?

Next week’s post: A proposal to avoid future repeats of Europe’s sovereign debt crisis.

These matters were discussed in a session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 10, 2011. Video & slides are available, including my own comment.

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