Re: Contagion
The only way to contain a Greek exit
The only way to contain a Greek exit - FT.com
May 16, 2012 7:20 pm
By Lorenzo Bini Smaghi
The latest episode of the eurozone crisis casts doubt on the basic premise of most economic models – that economic agents, and governments, always act rationally, after assessing the costs and benefits of alternative options.
Over the past two years, Greece has repeatedly stated its intention to stay in the eurozone, the cost of leaving it being much higher than that of implementing the policy adjustment required to remain a member. At the same time, Greece systematically tried to water down and postpone the adjustment measures, expecting the International Monetary Fund and Eurogroup ultimately to give in to avoid the financial contagion that would result from a Greek exit. But the European authorities never blinked and, each time, the Greek government and parliament had to rush to approve the measures before the deadline. The last-minute decisions were justified to the people with the need to meet Europe’s conditions.
The recent elections confirmed that Greek voters want to stay in the eurozone, but imagine they can do so on better terms. Again, Europe and the IMF did not blink. A new Greek election may further boost the anti-euro camp, fuelled by expectations that Europe will eventually waver and that the costs of exiting the euro might not be that large after all.
Europe faces a dilemma.
It cannot yield to Greek requests to renegotiate the programme. First, because this would be contrary to the established principle, that agreements are made between states and that governments make commitments for longer than their term of office. Second, because it would indirectly strengthen the position of parties campaigning in several countries (especially the peripheral ones) on an anti-euro platform, by suggesting that these parties could ultimately force European institutions to water down austerity programmes and provide more financing. Finally, such a change would be rejected by the other main creditors, in particular the IMF and its non-European shareholders, which were already reluctant to accept the exceptional financial support to Greece.
On the other hand, there is no doubt that if Greece leaves the eurozone the contagion will be devastating. Those who suggest that markets are now well prepared for such an event and that most of the costs would be borne by the Greek economy seriously underestimate the channels of transmission of systemic crises following a sovereign debt crisis and a bank run. As we saw after the fall of Lehman Brothers, quick decisions would have to be taken to set up credible firewalls and stop market panic. The US Congress had to adopt the troubled asset relief programme, used to recapitalise all banks in a coercive way, and the Federal Reserve implemented its series of quantitative easing.
European institutions have so far been reluctant to adopt a “bazooka solution”, for fear of moral hazard. Several times already, countries in difficulty have relaxed their efforts at adjustment soon after obtaining additional financing. However, relying on markets to keep the pressure on governments is costly, inefficient and increasingly unacceptable to voters. Populists who argue that markets should not dictate economic management in democracies are gaining ground everywhere. Such arguments create the illusion that there are easy ways out and distract voters from rational decisions.
Europe’s history over the past century should teach us not to underestimate the risk of collective irrationality and the dangers of populist politicians. The best way to avoid moral hazard in the middle of a financial crisis is not necessarily to let countries fail or to use market pressure, but to build stronger institutions and better rules. This applies also to Europe. After all, the EU was created precisely to avoid the irrationalities of the past.
The only way for Europe to protect itself against the irrational behaviour of Greece is to strengthen its own institutions and rules. So far, the main opposition in the eurozone has come from France, which has systematically striven to preserve the inter-governmental nature of the eurozone decision making and to contain the powers and legitimacy of the European Commission and European Parliament. Several countries, including Germany, have made different proposals, with a view to increasing the federal nature of European institutions.
If the eurozone is to overcome the crisis and avoid the contagion that would arise from one of its members leaving, it has to display the same ability as the US, after Lehman’s collapse, to take rapid actions to restore confidence and stability. This requires stronger and quicker majority-based decision-making in the eurozone, on issues such as banking capitalisation and resolution regimes, the provision of financial assistance to countries in difficulties, budgetary discipline, implementation of structural reforms, and so on. If François Hollande wants a “growth compact”, he must stand ready to accept Angela Merkel’s request for greater political integration and stronger fiscal rules. That is where a common ground can be found.
At that point Greece may decide whether to stay in or not.
The writer is a visiting scholar at Harvard university and a former member of the ECB’s executive board
