Has the vast blob of financial support now made available to Greece saved the Eurozone? Or merely bought time?

Baseline Scenario drills down into what it says is the core question (my emphasis):

If Mr. Trichet and Mr. Strauss-Kahn were honest, they would admit to Ms. Merkel “we messed up – more than a decade ago, when we were governor of the Banque de France and French finance minister, respectively”.  These two founders of the European unity dream helped set rules for the eurozone which, by their nature, have caused small flaws to turn into great dangers. 

The underlying problem is the rule for printing money:  in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. 

The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits.  The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels. 

… Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join.  No wonder also that it blew up.  Nations with profligate governments or weak financial systems had a bonanza.  They essentially borrowed funds from the less profligate elsewhere in the eurozone, backed by the ECB…

Senior US economist Martin Feldstein created a noise back in 1997 when he suggested that the Eurozone might create real conflict in Europe: economic problems in individual countries would no longer be manageable by letting the exchange rate do some of the work, which in turn would lead to national populations starting to blame each other for collective problems.

Which, lo and behold, is just what is happening now. Germans denounce ‘Greek’ irresponsibility. Greeks rail against ‘German’ selfishness and lack of solidarity.

Here is Martin again now, in feisty form:

Greece will default on its national debt. That default will be due in large part to its membership in the European Monetary Union. If it were not part of the euro system, Greece might not have gotten into its current predicament and, even if it had gotten into its current predicament, it could have avoided the need to default.

Greece’s default on its national debt need not mean an explicit refusal to make principal and interest payments when they come due. More likely would be an IMF-organized restructuring of the existing debt, swapping new bonds with lower principal and interest for existing bonds. Or it could be a “soft default” in which Greece unilaterally services its existing debt with new debt rather than paying in cash.

But, whatever form the default takes, the current owners of Greek debt will get less than the full amount that they are now owed…

 

In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt. At that point, Greece will default.

 

Some of the financial manoeuvres now being launched by the European Central Bank to try to hold the line are far beyond my modest comprehension. Whether they are wise or a lawful use of the powers available under EU treaties remains to be seen.

But is it not all quite simple in substance?

I last year took out a long-term fixed mortgage and was very pleased with myself. But then someone said that in effect I was betting against the bank: "You think you’ll do better on interest repayments over that ten-year period than the bank – the bank thinks that it will do better than you".

Hmm.

Any loan is an intelligent guess about the future.

If X lends Y money, X is taking a step into the unknown and making a judgement: will Y be able to pay that money back and be trustworthy enough to do so?

The interest rate X charges Y on the loan serves various subtle functions. It measures X’s trust in Y’s credibility and prospects, plus it balances the benefit of lending the money to Y against what might have happened if the money had been lent to Z instead.

What if Y borrows and borrows and borrows to a stupid or at least highly unwise degree? Y gets into trouble with debt repayments.

There are then several options for Y:

  • work harder to earn more money to repay X
  • sell off assets to generate money to repay X
  • negotiate freely with X a different deal, eg reduced payments now but more later when things improve
  • borrow more money from Q to repay X (maybe on less favourable terms, but at least it buys some time)
  • threaten not to repay X and to spread problems, to get concessions
  • a combination of all of the above

Any or all of these make sense – IF people think that Y is still able to repay at a sensible rate down the road.

But if people think that Y has fatally messed up everything and has created chaos, the only point in lending Y more money is not to help Y but to try to maintain wider ‘confidence’ in lending and so head off other bigger problems.

Which is where the Eurozone appears to be now.

What in substance we are seeing is the beginning of the end of the ‘European Social Model’.

Because as times get trickier the markets are looking a lot harder at how governments plan to pay their debts down the road, as demographic and other trends work against unfunded wasteful state-run social schemes of vast proportions.

And maybe, at a level even deeper than that, is an emerging realisation that governments can no longer rely on the monopoly method they have used down the centuries.

To use force to take assets from the productive part of the population to pay for ever-more elaborate collectivist schemes. Or, failing that, borrow money from other suckers and hope for the best. See Greece and California, passim.

When you hear the usual suspects banging on about the greed and fecklessness of ‘bankers’, remember that it was a number of highly paid top European politicians who set up the Eurozone’s rules in ways which defied elementary logic and common sense:

I recently talked to a German expert who was closely involved in setting up the Eurozone. He identified the single biggest mistake:

"It simply did not occur to us that another EU country would tell lies about its own situation."

The Eurozone’s various rules indeed were intended to keep would-be wayward governments in line, absent the financial controls in a unitary jurisdiction.

But rules work only insofar as there are shared assumptions about what those rules are.

It turns out that the the Eurozone has no such shared assumptions…

Update: Nicely put by Roger Bootle in the Telegraph:

After Thursday, our own politicians will have to confront the markets in all their brutality. Whatever the result of the election, they will probably suspend judgment for a time, while the politicians sort themselves out. Within a matter of weeks, though, they will want answers.

It is true that Britain is not Greece. We are in a much stronger position. But not long ago even Greece wasn’t Greece.