Financial markets are beginning to feel a little more relaxed about the future of the euro, but there is a critical missing element in the current policy discussion. With attention focused on Spain's larger-scale problems, it would be easy to forget that Greece is still on an unsustainable path, with no solution in sight.
The story starts back in May 2010 when Greece, clearly insolvent, was treated as if it was merely illiquid and just needed more time to reduce its excessive government debt. It was insolvent not just because the debt was large, but because there was no realistic prospect that the Greek political process could make the herculean policy changes required.
Since then the debt has been 'kicked down the road' in various ways, with the main effect being to transfer most of it from the private sector to various parts of the European official sector (including the European Central Bank). It's not surprising that the European decision-making process favoured this flabby non-solution, but a well-functioning IMF would have stood its ground and insisted on a fundamental rescheduling (de facto default) at that stage.
This would have changed the politics in a beneficial way. Default would have damaged French and German bank balance sheets, but the taxpayers of those countries would have been more ready to support their banks than to assist the feckless Greeks. In Athens, without the ability to borrow, the government would have had to run a balanced budget. Pensioners and public servants would have been demonstrating on the streets, but rather than criticising the IMF, they would have been demanding that taxes should be collected so that they in turn could receive their salaries and pensions.
This opportunity was lost and the private creditors (who made the mistake of investing in Greek debt in the first place and who should have lost all their money) have largely managed to unload their assets, albeit with some haircut.
The problem remains: unless the debt slate is wiped clean, the future of the Greek economy is dismal. Why would any young well-educated Greek stay home, facing a lifetime of high taxes and penny pinching government services? Those who can emigrate will do so.
Why would any investor (Greek or foreign) put their money in Greece, knowing that a permanent tax squeeze will be in place? Why would any foreign portfolio manager buy newly-issued Greek debt, knowing that this new debt was adding to an existing debt mountain? Without strong growth, government debt is patently unsustainable.
In short, Greece can't get onto a sustainable debt profile unless the existing debt slate is wiped clean (or something pretty close to clean). This is what Iceland did by defaulting in 2009. Foreign investors, far from being deterred by the country reneging on its debt, realised that new debt would be repaid because the old debt had not been. Iceland successfully issued new debt.
Behind closed doors, the European policy makers and the IMF both now recognise this reality. They are inching their way towards a solution, but face an insurmountable problem. The various European funding possibilities (European Financial Stability Fund, European Stability Mechanism, European Central Bank) can't tolerate a simple unambiguous default.
Their resources could be used to reduce the actual burden of Greek debt (through much longer maturity and much lower interest rates) provided that it is called a 'voluntary rescheduling', not a 'default'. It doesn't matter that the longer maturity and low interest rate dramatically reduce the true value of the debt (and if proper accounting were to be applied, the debt would have to be dramatically written down on balance sheets, including the ECB).
But if this semantic sleight-of-hand is needed for the European legal and political system, different semantics would be needed to convince Greece's smart younger people to stay home to get the Greek economy going, and investors to give them the capital to do so. Both these groups need to be assured that tax rates will be much the same as other countries and that the budget will be able to provide normal levels of support. Without an unambiguous debt write-off, their growth-enhancing entrepreneurship will go elsewhere.
The policy dialogue is changing, becoming more realistic. Just about everyone now accepts that strong austerity is bad for growth. The IMF is warning that the multipliers involved in fiscal tightening seem to be uncomfortably large (see Box 1 in the current IMF World Economic Outlook).
Just about everyone has lost faith in the confidence fairy: the unlikely notion that tough fiscal policy would raise confidence and thus boost growth. The UK looks as though its 'courageous' (in Sir Humphrey's use of the term) budget austerity will be softened.
The European authorities have the EFSF and ESM to help funding pressures and the ECB is ready to do Outright Monetary Transactions to help bond markets. There are moves towards 'more Europe': bank supervision by a single European supervisor and fiscal union.
All this is moving in the right direction and financial markets are reacting positively. But 'more Europe' will take a generation to put in place and in the meantime no-one has yet reconciled Europe's need to avoid Greek default with Greece's need to wipe the debt slate clean.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.