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Europe Needs a Plan B for Greece

Greece has gotten out of trouble, temporarily, for a few times this year now. But the solution did not solve the fundamental problem. You can't just solve debt and credit problem by throwing more money at it.  WSJ reports tough roads ahead for Europe in 2011-2 and beyond.

Third time lucky? Two mostly political agreements in recent months failed to ease market fears about Greece. The euro-zone's latest promise—to provide up to €30 billion ($40.49 billion) in loans, with the International Monetary Fund expected to offer another €10 billion to €15 billion—should finally remove any short-term liquidity risk. But in the longer term, the deal does little to address fundamental questions about the euro zone. Sunday's agreement still contains seeds of doubt.

Even the clearest, most credible part of the deal, the interest-rate mechanism, raises questions. On one level, charging 5% for a three-year fixed-rate loan represents a concession when compared with last week's market levels. But this is still 3.7 percentage points over German Bunds—a long way north of where Greeks would like to be able to borrow.


Indeed, if Greece were to take a 10-year loan under the package, it would be at a rate of well over 7%, the rate the market would have charged last week. The package as it stands could mean an increasing reliance on short-term funding for Greece, boosting rollover risk and creating a refinancing hump in exactly the same way as the provision of government guarantees did for banks. And in a curious way, the euro-zone rate may actually act as a floor for private market rates. Why should a bond investor lend money to Greece more cheaply than other euro-zone governments are willing to?

Any actual disbursement will also raise further political questions, with the euro-zone effectively taking a step toward greater fiscal transfers. Spain, Portugal and Ireland will be expected to help Greece even as they battle with their own budget deficits and economic rebalancing. The amounts are relatively small—Ireland, for instance, says it might have to contribute €450 million—but they may still stick in the craw and act as a disincentive to carry through the harsh measures necessary at home. Short-term bond yields edged lower for these countries, too, on Monday, but investors could yet test Europe's willingness to offer similar deals to other weak countries.

The euro zone should be working on a Plan B, if it wishes to retain credibility. The real challenge in Greek fiscal consolidation may come in 2011 or 2012. The need may yet arise for a mechanism that allows an orderly restructuring of sovereign debt within the euro zone, just as policy makers are seeking a solution to unwind systemically important banks that get into trouble.

Such a mechanism, if credible, could even strengthen the euro as an institution. Sunday's deal perhaps buys policy makers time. They need to be prepared for the eventuality that Greece does end up following in the footsteps of Argentina, which defaulted after a decade of IMF bailouts.

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