June 23 (Bloomberg) -- George Papandreou was staring into a 20 billion-euro ($29 billion) hole.
It’s common for freshly minted leaders to discover that there’s not enough money to pay for their campaign promises. So when Papandreou’s new Greek government woke up to a looming budget disaster within days of taking office in October 2009, the alarm bells were slow to ring in European capitals.
Don’t “overrate” the problem, said German Chancellor Angela Merkel, later to play a pivotal role in the debt saga that continues to rock the 17-nation euro area. “There are deficits in other parts of the world as well.”
That initial reaction foreshadowed European leaders’ failure to tame a crisis that is entering its 21st month and has world leaders growing anxious over the prospect of a new financial tsunami as they shake off the effects of the last one. On June 7, President Barack Obama told Merkel it was her job to stop an “uncontrolled spiral of default.” China’s central bank warned on June 14 of a “major risk” incubating in Europe.
“This has unravelled badly,” said Paul de Grauwe, an economics professor at the Catholic University of Leuven in Belgium and a two-time candidate for a European Central Bank post. “The most favorable scenario is that we can bridge the next six months. The less favorable scenario is this gets out of control.”
The 256 billion euros in aid committed to Greece, Ireland and Portugal have done little more than buy time against a looming default, says Andrew Balls, Pacific Investment Management Co.’s head of European portfolio management. The cost to insure senior debt of 25 banks and insurers has climbed to 162 basis points from 120 on April 8, according to JPMorgan Chase & Co. prices. Insurance against a sovereign default, the most expensive in the world, indicates a chance of more than three in four that Greece will be forced to restructure its debt.
“If you just look at the economics, it looks pretty hopeless for Greece. It would make you think that a default would already have happened,” Balls told Bloomberg Television June 21. “If you can quarantine Greece, Ireland and Portugal, take these countries out of the market, have them do their adjustments, then you can buy time for Spain, buy time for banks to recapitalize.”
At a Brussels summit tonight and tomorrow, the stewards of the world’s second-largest economy will have another go at the Greek dilemma, debating the size of new loans to the Athens government and how to get holders of Greek bonds to chip in.
Already, European Union leaders are playing down the prospects of a lasting fix at the summit -- and this, three months after proclaiming a “comprehensive” solution to a crisis that, for all the angst, has been limited to countries with a combined 6 percent of the euro area’s gross domestic product.
“Times are difficult,” EU Economic and Monetary Commissioner Olli Rehn said on June 20. “Reform fatigue is visible in the streets of Athens, Madrid and elsewhere, and so is the support fatigue in some of our member states.”
Police in Athens used tear gas to break up protests against austerity measures last week. Demonstrators who have camped in front of the Greek parliament for four weeks have labelled a poster of Papandreou as the International Monetary Fund’s “employee of the year.”
Europe’s debt chain reaction exposed what Romano Prodi, who as Italian prime minister shepherded Italy into the euro, called a “half-baked” setup. The monetary half run by the European Central Bank has delivered low inflation. The fiscal and economic management half has been all over the map.
Another split is emerging, between the wealthier, more export-driven and fiscally restrained north and the poorer south, now facing years of subpar growth, according to the Centre for Economics and Business Research.
“Euro to break up -- not this week but probably by 2013,” the London-based CEBR headlined on June 20, adding a voice to those who have been wrong so far. Greece will be the first to go, opting for growth and jobs over euro-mandated austerity, the research firm predicted.
The accident that Merkel didn’t see coming -- and the EU still sees as a cash squeeze, not an existential matter of solvency -- intruded on the EU leaders’ agenda for the first time on Feb. 11, 2010, in the century-old Solvay Library in Brussels at what was billed as a brainstorming session on a 10-year economic strategy, focused on productivity and innovation.
At the time, Greek 10-year bonds yielded 6.03 percent. The extra yield over German bonds, a measure of the risk of investing in Greece, was 283 basis points.
Three months later, with the risk spread nearing 1,000 basis points, jousting among Merkel, French President Nicolas Sarkozy and ECB President Jean-Claude Trichet yielded a decision to establish an emergency lender to prop up debt-wracked states. In so doing, the leaders set aside a core euro principle that each country was the master of its own finances.
At 2 a.m. on May 10, as markets opened in Asia, the details were set. Europe created two funds, of 60 billion euros and 440 billion euros, and the IMF put up 250 billion euros. The ECB went into the bond-buying business.
The first phase of the crisis was over and the markets settled down.
In October, they awoke with a clatter. In an Oct. 18 tete-a-tete in Deauville, on France’s English Channel coast, Merkel and Sarkozy decided it was time to shift the costs of saving the euro from taxpayers to bondholders. Merkel won French backing for a permanent rescue fund with the option of putting states into default.
Investors didn’t like what they heard. While Merkel’s “private investor participation” provisions wouldn’t kick in until mid-2013, the mere floating of the idea made bonds of deficit-plagued states such as Ireland, Portugal and Spain less attractive.
Phase two of the crisis was under way, with a front opening over how creditors would contribute to the rescues.
From the latter half of October into November, investors dumped bonds of countries on Europe’s periphery. Ten-year Irish yields rose from 6 percent on Oct. 18, the date of the Merkel-Sarkozy beachside promenade, to 9.2 percent on Nov. 26, prompting Ireland’s capitulation. The yield is now 11.7 percent.
Ireland’s 67.5 billion-euro bailout package on Nov. 28 came along with what Trichet called a “useful clarification”: chastened by the plunge in Irish, Portuguese, Spanish, Italian and Belgian securities, Germany diluted demands for a future “orderly default” procedure.
What at first looked like peace with the bond markets turned out to be a short-lived armistice. In Brussels and European capitals, work proceeded on upgrading the temporary rescue fund, setting up the permanent one and tightening the “stability pact” that had proven toothless in enforcing the euro area’s deficit and debt rules.
Politics in Germany and Finland delayed agreement on the strengthened rescue mechanism until June. Each country now plans to boost its guarantee, enabling the fund to tap the full 440 billion euros promised on the dramatic May weekend, and to buy bonds directly from straitened governments.
“Crises thrive on uncertainty, and the officials are providing that in large doses,” Alessandro Leipold, a former acting director of the IMF’s European department, said on Bloomberg Television. “The decisions are too politicized. It really is time for once for them to surprise us on the upside and actually anticipate the market.”
All the while, there was a slow burn in Portugal, the originator of Europe’s “Lisbon agenda” of 2000 that set the goal of turning the EU into the world’s most competitive economy by 2010.
Few countries landed wider of that mark. Portugal’s GDP per capita, a measure of wealth and productivity, was 81 percent of the EU average in 2010, the lowest in western Europe and barely ahead of the ex-communist Czech Republic, at 80 percent.
Portugal’s implosion ended the taboo against European authorities intervening in national politics. With the crisis triggering early elections, the euro area and IMF forced both main parties to sign up to budget cuts in the heat of the campaign as a condition for 78 billion euros in loans.
By then, Germany and the bond market were falling out. It began April 14 when Finance Minister Wolfgang Schaeuble hinted at the need for a Greek debt restructuring in a Die Welt newspaper interview. A day later, Deputy Foreign Minister Werner Hoyer told Bloomberg News that a restructuring “would not be a disaster.”
Germany’s thrust came with Greece’s 10-year yield premium at 948 basis points, virtually unchanged since New Year’s Day. It quickly deteriorated. By May 16, the day of Portugal’s bailout, it was 1,250 basis points. It peaked last week at 1,503 basis points.
German musings about shoving Greece into default met pushback from the ECB and France, the country most exposed to Greek debt. A new confrontation over bond contracts and market psychology played out, ending in a German climbdown.
Merkel blinked on June 17. With Sarkozy at her side, she dropped the idea of a compulsory Greek debt exchange that would lead rating companies to place Greece in default. “Let me make that perfectly clear,” Merkel said. The ECB now had a veto over the method for getting bondholders to roll over Greek debt.
It was the squabble and not the agreement, though, that raised eyebrows.
“It’s very hard for people to invest in Europe, within Europe and outside Europe, to understand what the strategy is when you have so many people talking,” U.S. Treasury Secretary Timothy F. Geithner said June 21. “It would be very helpful to have Europe speak with a clearer, more unified voice.”
In the meantime, Greece was failing to keep up its end of the bargain. While Papandreou delivered 20 billion euros of EU-and IMF-ordained budget cuts in 2010, the resulting 4.5 percent economic slump squeezed tax revenue, leaving the deficit above target and debt on an upward trajectory.
Already at a European record of 142.8 percent of GDP, Greek debt is set to rise to 157.7 percent this year and 166.1 percent next year, the EU predicts. It prodded Greece to get serious about selling 50 billion euros of state assets to pay off creditors, pushing the government to the breaking point.
Unable to lure the opposition into a unity coalition, Papandreou, 59, the Minnesota-born scion of a political dynasty, replaced his finance minister last week, stiff-armed an inner-party rebellion and staked his future on a confidence vote.
Papandreou Hangs On
The interim climax came early yesterday. As 10,000 protesters besieged the parliament in Athens, hurling bottles and fruit at riot police, the Socialist convert to spartan economics warned the assembled lawmakers that Greece had run out of alternatives.
The government survived, by a margin of 155 to 143. Votes next week will determine the fate of 78 billion euros in budget cuts, the price demanded by the EU and IMF in exchange for a 12 billion-euro loan installment to banish the specter of default, at least through August.
Risks are rising of “a Lehman-esque event rippling out from Europe,” said Carl Weinberg, chief economist at High Frequency Economics Ltd. in Valhalla, New York. “Things are out of control. We’ve been reduced to a game of chicken between Greece and the governments of Europe to see who blinks first.”
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