Greece and Europe Play Financial 'Chicken'
Daniel McDowell | 18 Feb 2010
Like a storyline out of a classical tragedy, the euro is being punished for the sins of Greece. The Hellenic Republic's massive debt has shaken market confidence in the common currency and led to a volatile month in its exchange rate. Feeling increasing pressure to intervene, European policymakers have been forced to weigh what is best for the euro against what public opinion will tolerate. For now, none of the choices are appealing. Nonetheless, a decision must be made, and as this game of "financial chicken" unfolds, the only thing certain about the outcome is that no one is likely to be happy with it.
Spending too much, taxing too little, and borrowing too heavily: As vicious cycles go, Greece's was both simple and effective. But when a country consistently shows a lack of fiscal discipline, financial markets often impose discipline of their own. Greece is no exception. As it became clear that the country's debt -- two-thirds of which is held by foreigners -- was unsustainable, markets began to fear that Athens might default. Besides downgrading the country's credit rating last month, markets also began to pressure Athens' currency -- the euro.
Because of the common currency, the Greek headache has now become a European migraine. The past several weeks have seen the euro fall against the dollar, leaving Europe faced with a dilemma: bail out Athens and protect the Euro, or leave Greece to the wolves and risk further decline in the euro's value and stature.
Between these stark extremes, of course, lie a range of options, each with its own set of costs, benefits and likely consequences.
First, Europe could decide to bail out their Athenian friends. If private markets are no longer willing to buy up Greek debt because they fear default, European economies in better fiscal shape could step in and play this role. This would keep the Greek government afloat, enabling it to continue servicing debt as it comes due. Eliminating the threat of default should, in theory, reduce the pressure on the euro and bring the currency situation under control.
However, such a move would set a dangerous precedent, by signaling to other eurozone economies that no matter how undisciplined they might be, their EU partners will always come to the rescue. This raises the dreaded specter of "moral hazard": the idea that when economic actors are insulated from risk, they are more prone to engage in risky behavior -- such as accumulating an unsustainable amount of debt. So a bailout might solve the short-term problem, but unless it came with strict conditions requiring Athens to get its deficits under control, it could also invite subsequent sequels.
So far, Old Europe, led by Germany, has shown little desire to send a single euro to Greece, based largely on moral hazard grounds as well as the extreme unpopularity of such a move among its public.
A second option would be an IMF bailout. This would function similarly to a European-led bailout, but because the IMF would be better-positioned to demand the necessary harsh reforms from Greece, it would limit the moral hazard effect. But so far, Greece's EU partners have shrunk from the thought of calling in the IMF to defend the vaunted euro.
A third option that has been mentioned, if in whispers, is to simply kick Greece out of the eurozone -- a move that the Dutch favor by overwhelming numbers, according to a recent poll. There are two main problems with this, however. First, there is no legal basis for such a move, as the original treaties do not contain an exit clause. Second, it would be self-defeating. Booting out Greece could cause markets to speculate that other countries like Spain or Portugal are next, forcing the euro lower still.
A fourth option would simply be for Europe to turn its back on Athens and refuse a bailout, a decision that would in all likelihood send Greece careening toward the largest sovereign default in history. And while this would send a clear message to all eurozone countries that they are on their own if they act irresponsibly, it would also be self-destructive for the other eurozone economies. The currency union acts as a "financial NATO" of sorts, where an attack on one member's currency is literally an attack on all members' currency.
Consequently, other eurozone economies have little choice but to come to the defense of their beleaguered partner. But in so doing, they will try to include conditions requiring Athens to rein in deficits through tax hikes and spending cuts, especially in public sector wages. While such reforms are clearly necessary, the austerity measures already implemented have not gone over well with the Greek public and government workers unions. But Europe appears unwilling to open the financial floodgates until Athens agrees to even more painful terms, to which the Greeks have essentially replied, Thanks, but no thanks.
As a result, a game of "financial chicken" is emerging, with each side waiting to see who will blink first. Greece is holding out until Europe sends in the cavalry, while Europe is holding out until Athens agrees to its terms. Meanwhile, the markets hang on policymakers' every word and place their bets accordingly, sending the euro up and down with every bump on the road toward a resolution.
The most likely coordination point is somewhere in the middle. In order to protect itself, Europe has little choice but to assist Athens. Yet, in order to quell moral hazard concerns and domestic political objections, they have an interest in making their aid package as painful for the Greeks as they can. This would send a message to the eurozone that, yes, monetary union implies solidarity, but fiscal irresponsibility does not come without costs. And while neither party will be terribly happy with this result, it's the one outcome that avoids a tragic end.
Daniel McDowell | 18 Feb 2010
Like a storyline out of a classical tragedy, the euro is being punished for the sins of Greece. The Hellenic Republic's massive debt has shaken market confidence in the common currency and led to a volatile month in its exchange rate. Feeling increasing pressure to intervene, European policymakers have been forced to weigh what is best for the euro against what public opinion will tolerate. For now, none of the choices are appealing. Nonetheless, a decision must be made, and as this game of "financial chicken" unfolds, the only thing certain about the outcome is that no one is likely to be happy with it.
Spending too much, taxing too little, and borrowing too heavily: As vicious cycles go, Greece's was both simple and effective. But when a country consistently shows a lack of fiscal discipline, financial markets often impose discipline of their own. Greece is no exception. As it became clear that the country's debt -- two-thirds of which is held by foreigners -- was unsustainable, markets began to fear that Athens might default. Besides downgrading the country's credit rating last month, markets also began to pressure Athens' currency -- the euro.
Because of the common currency, the Greek headache has now become a European migraine. The past several weeks have seen the euro fall against the dollar, leaving Europe faced with a dilemma: bail out Athens and protect the Euro, or leave Greece to the wolves and risk further decline in the euro's value and stature.
Between these stark extremes, of course, lie a range of options, each with its own set of costs, benefits and likely consequences.
First, Europe could decide to bail out their Athenian friends. If private markets are no longer willing to buy up Greek debt because they fear default, European economies in better fiscal shape could step in and play this role. This would keep the Greek government afloat, enabling it to continue servicing debt as it comes due. Eliminating the threat of default should, in theory, reduce the pressure on the euro and bring the currency situation under control.
However, such a move would set a dangerous precedent, by signaling to other eurozone economies that no matter how undisciplined they might be, their EU partners will always come to the rescue. This raises the dreaded specter of "moral hazard": the idea that when economic actors are insulated from risk, they are more prone to engage in risky behavior -- such as accumulating an unsustainable amount of debt. So a bailout might solve the short-term problem, but unless it came with strict conditions requiring Athens to get its deficits under control, it could also invite subsequent sequels.
So far, Old Europe, led by Germany, has shown little desire to send a single euro to Greece, based largely on moral hazard grounds as well as the extreme unpopularity of such a move among its public.
A second option would be an IMF bailout. This would function similarly to a European-led bailout, but because the IMF would be better-positioned to demand the necessary harsh reforms from Greece, it would limit the moral hazard effect. But so far, Greece's EU partners have shrunk from the thought of calling in the IMF to defend the vaunted euro.
A third option that has been mentioned, if in whispers, is to simply kick Greece out of the eurozone -- a move that the Dutch favor by overwhelming numbers, according to a recent poll. There are two main problems with this, however. First, there is no legal basis for such a move, as the original treaties do not contain an exit clause. Second, it would be self-defeating. Booting out Greece could cause markets to speculate that other countries like Spain or Portugal are next, forcing the euro lower still.
A fourth option would simply be for Europe to turn its back on Athens and refuse a bailout, a decision that would in all likelihood send Greece careening toward the largest sovereign default in history. And while this would send a clear message to all eurozone countries that they are on their own if they act irresponsibly, it would also be self-destructive for the other eurozone economies. The currency union acts as a "financial NATO" of sorts, where an attack on one member's currency is literally an attack on all members' currency.
Consequently, other eurozone economies have little choice but to come to the defense of their beleaguered partner. But in so doing, they will try to include conditions requiring Athens to rein in deficits through tax hikes and spending cuts, especially in public sector wages. While such reforms are clearly necessary, the austerity measures already implemented have not gone over well with the Greek public and government workers unions. But Europe appears unwilling to open the financial floodgates until Athens agrees to even more painful terms, to which the Greeks have essentially replied, Thanks, but no thanks.
As a result, a game of "financial chicken" is emerging, with each side waiting to see who will blink first. Greece is holding out until Europe sends in the cavalry, while Europe is holding out until Athens agrees to its terms. Meanwhile, the markets hang on policymakers' every word and place their bets accordingly, sending the euro up and down with every bump on the road toward a resolution.
The most likely coordination point is somewhere in the middle. In order to protect itself, Europe has little choice but to assist Athens. Yet, in order to quell moral hazard concerns and domestic political objections, they have an interest in making their aid package as painful for the Greeks as they can. This would send a message to the eurozone that, yes, monetary union implies solidarity, but fiscal irresponsibility does not come without costs. And while neither party will be terribly happy with this result, it's the one outcome that avoids a tragic end.