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“Soft” Budget Rules
Similar to the soft budget constraints (or SBC) under former socialist countries, the budget rule under EU treaty is also “soft” in a sense that violating the rule won’t be really punished. Punishments, such as kicking the “rogue” member country out of the union, run contradictory to the political ambition of the European Union and would risk breaking the union altogether.
The other option is to rein in the government spending of the member countries. But that would require a centralized authority with direct control of the member countries, especially on their fiscal policies, i.e., how governments spend their money. At current stage, Europe is not ready for such radical change, which requires a big surrender of their own sovereignty. So what Europe will likely end up is a fake fiscal union with soft budget rules. The moral hazard problem is unsolved. Rest assured to see more budget rule violations in the future.
The following map from WSJ gives a very nice summary of how the union’s budget rule had been violated in the past.
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EU entered recession, likely a long one
According to Paul Kasriel at Northerntrust, most likely the EU entered recession this quarter.
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“The Greek tragedy morphed into an Italian comedy. Now, it has become a French farce”. Bank credit is set to slow down or contract.
Of course, the European Central Bank (ECB) could step in to create some of the credit that EU MFIs otherwise would be creating under normal circumstances. But the ECB fears that quantitative easing would somehow sully its Bundesbankian reputation. How ironic that the ECB, a central bank ostensibly sympathetic to an Austrian approach to monetary policy, would not try to maintain a normal amount of credit creation when MFIs were unable to do so. Europeans, get ready to join your Japanese brethren for a lost decade. It did not have to happen for the Japanese and it does not have to happen for the Europeans. But given the intransigence of Japanese and European central bankers (with the exception of British central bankers), it will.
Will Greek default end the Euro?
Daniel Gros at WSJ asks the interesting question:
The real question is: Would a messy (and massive) default under which the country refuses to repay in full signify the end of the euro?
Yes and no.
A messy default would certainly end the ideal of the euro area as a club whose members are all equal and work toward a common goal, namely the stability of the common currency. Membership in such a club protects against financial problems, because members are supposed to behave well and help each other in case of unjustified speculative attacks. Although the EU Treaty says that members are not liable for each other’s public debt, there is an implicit political commitment, as we see right now, to provide emergency help.
The quid pro quo for this solidarity is of course the expectation that all members abide by certain standards, for example those embodied in the Stability and Growth Pact, that aim to limit budget deficits and debts. The continuing misreporting of fiscal data by Greece has already severely damaged this ideal. But the “club” could still be saved if Greece undertook a determined national effort to service its debt and avoid a messy default.
However, even a messy default by Greece alone would not necessarily mean the end of the euro area. The day after a formal default, Greek banks would no longer have access to the regular monetary policy operations of the European Central Bank. The ECB could no longer accept their collateral, Greek debt, which would immediately have less than junk status. The country would thus effectively cease to be part of the euro area. Its status would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone.
In Greece, following a messy default, euro notes and coins would still circulate in the economy, but one euro on a Greek bank account would no longer be automatically equivalent to one euro on a bank account elsewhere in the euro area, as Greek banks might immediately become insolvent and thus be shut out of the payment systems. Until Greek solvency has been re-established, the euro zone would thus de facto have lost one of its members—although the Greek Central Bank head would still sit on the Governing Council of the ECB, and the Greek finance minister would still be a member of the Euro Group, with his country’s normal voting powers intact.
The Greek economy would collapse, but the impact on the rest of the single currency zone should be minor, given that the country represents only about 2% of the euro area’s GDP and is not home to any systemically relevant financial institution.
In many ways, a Greek default would leave the euro zone in better shape. Its institutions would probably be strengthened, because it would have become clear that the framework is strong enough to withstand the failure of one of its members. Tolerance toward deficit violations and inaccurate reporting would be much reduced. The club would have been transformed into a federation whose peripheral components can be told to “get lost,” so to speak. As a result, majority voting would tend to replace consensus as the normal way of decision-making.
The potential monkey wrench is contagion. The main reason Germany is now agreeing to accelerate the Greek bailout package is that tension on Spanish financial markets has arisen over the past several days. In contrast to Greece and Portugal, Spain (and even more so Italy) are indeed “too big to fail.”
Will contagion prove fatal? The fundamentals of Spain and Italy, especially their self-financing capacities, are much stronger than in Greece and Portugal. Moreover, neither Spain nor Italy would gain much from a default, since most of their public debt is held by their own citizens. A default would thus not lower the foreign debt of the country. For Greece, by contrast, 90% of all public debt is held by foreigners, who could be expropriated by a default.
However, markets can at times be irrational. The real test of the euro area is thus not Greece, but whether it can protect members that do not have an insolvency problem from speculative attacks.
The signals are so far mixed. After an initial bout of generalized nervousness in February, when it first became clear that the second leg of the financial crisis could imply sovereign default, financial markets have increasingly differentiated among the weaker members of the euro area. Risk premia have tended to move together in the same direction, but with completely different orders of magnitude. The spreads on Spanish bonds have increased, but they remain less than one third of those of Greece, with Italy even lower.
The fate of euro is not being decided in Athens, but in Madrid and Rome.
Not even the end of the beginning
WSJ analyzes why investors are still betting down Euro and Greece:
This is not the beginning of the end, not even the end of the beginning. The International Monetary Fund and euro zone’s €110 billion ($145.37 billion) three-year Greek debt support package still needs to be given final approval by 15 euro-zone leaders. They in turn must satisfy themselves—and their national governments and voters—that there’s a reasonable chance their loans can be refinanced, rather than turning into a straight fiscal transfer. That’s far from certain.
First, the plan does not buy Greece quite as much time as it appears. Of the €110 billion headline figure, €10 billion is going to a Financial Stability Fund to support Greece’s banks. Greece needs around €30 billion for 2010; for 2011-2012 debt and interest payments alone total €93 billion, according to Barclays Capital. So even with the program, Greece is likely to need to return to the markets in late 2011 or 2012. Ideally it would return as soon as possible, if the plan works.
Second, debt will still be rising in 2011 and 2012, topping out only in 2013 at an eye-watering 149% of GDP. In 2012, the budget deficit is still forecast to be 6.5% of GDP. Greece’s credit ratings may then be even lower than they are today; this may further complicate market access. Bond investors will have to be convinced already in 2011 that the debt trajectory and economy will turn around decisively, in order to engender private interest in Greek debt.
True, the new plan is at least realistic, recognizing the damage the economy will suffer: Greek GDP is assumed to shrink 4% in 2010 and 2.6% in 2011, before growing just 1.1% in 2012. The total fiscal adjustment of 11% of GDP is now in line with economists’ assumptions of the scale of effort necessary. And there will be quarterly monitoring of progress; International Monetary Fund involvement should boost credibility.
But the deal faces substantial execution risks: The Greek government is facing growing domestic opposition to its new austerity program announced last weekend, which includes further public-sector pay cuts and a VAT increase. Success also depends on global growth remaining robust as Greece is ill-equipped to deal with any fresh external shocks.
Euro-zone leaders may persuade themselves they have to endorse the package since any alternative, such as a restructuring, would be so traumatic. But they need to be clear about the risks: Even if the Greek economy performs in line with the IMF’s projections, they may yet need to provide further support packages as private lending starts to re-engage. The euro-zone’s engagement with Greece is likely to be a lengthy one.