It’s a funny thing, democracy: often messy, always unpredictable.
And so it is proving in Europe just now, after the announcement by Greece’s centre-left government under Prime Minister George Papandreou that it would actually ask its citizens in a referendum whether they wanted the most recent bail-out package from the European Union.
The decision to put the bail-out to a referendum comes only days after a tricky European summit in which German Chancellor Angela Merkel and French President Nicholas Sarkozy managed to cobble together an enhanced €130 billion bail-out fund for Greece, in return for a 50 per cent hair-cut for investors holding Greek government bonds. It sparked fresh sell offs in global markets and consternation in Cannes, where the leaders of the G20 are assembling.
For much of the past 18 months, Papandreou’s government has been pushing through austerity measures in the face of public opposition, including general strikes and riots on the streets of Athens. Panadreou, American-educated but the scion of a famous political family, is the head of the PASOK coalition and came to office on an election platform that had nothing to do with the savage government spending cuts he was subsequently forced to adopt.
Now, he appears to have gambled everything on a new public mandate for the bail-out and its associated austerity. Failure of the referendum — which on current polls seems likely — will almost certainly precipitate a default on Greece’s government debts and its exit from the eurozone.
How has it come to this? Simply, Greece is broke. A small European nation with a troubled post-war history, Greece has lived well beyond its means since transitioning from military dictatorship. Unlike ancient Athens, the modern Greek state lacks the silver mines of Laurium or the foreign tributaries that made its ancient counterpart rich — and cooked books and massive tax evasion haven’t helped either. As a result, the Aegean state now finds itself with government debts roughly twice the size of its annual economic output.
This, very briefly, is why Greece finds itself at the centre of a regional economic crisis. There’s no way Greece can pay its debts, and much of that debt is held by tottering European financial institutions, which will need bail-outs of their own if their large holdings of Greek bonds become suddenly worthless. The European financial crisis has already claimed two large victims in recent weeks, with the failure of big Belgian bank Dexia and this week’s collapse of US merchant bank MF Global.
Meanwhile, Greece itself is only keeping the lights on with regular injections of cash from its wealthier European neighbours, principally Germany and France.
But emergency bail-outs generally come with strings attached, and the Greek bailouts have been predicated on stringent austerity measures.
In return for regular loans worth billions of Euros that have allowed the Greek government to keep paying its public servants, Europe and the IMF have asked Greece to accept a lot of pain. Public sector spending has been slashed, government workers have had their wages cut by a quarter, taxes have been raised and social service benefits cut in an attempt to get Greece’s parlous public finances back into the black.
It hasn’t worked. Because austerity crimps government spending at the very time a country needs economic growth, austerity has exacerbated Greece’s economic situation. The September quarter economic data showed the Greek economy shrank by a devastating 7 per cent year-on-year. The government expects it to contract a further 5 per cent this year. With inflation at negligible levels, the shrinking economy means Greece’s debts are increasing as a proportion of its GDP: the country (and arguably the eurozone more generally) is trapped in "debt deflation", the vicious downward cycle first identified by Irving Fisher in the 1930s.
As I explained here in New Matilda earlier this year, heavily indebted nations traditionally have three escape hatches: economic growth, currency devaluation and inflation, or default. Greece is not going to start growing again under present policy settings. It can’t devalue or inflate its currency: its currency is the Euro, which is the crux of the problem. Default beckons.
As a result, Greece is now effectively a zombie nation. Clearly insolvent, the issue has now become how Greek default will be handled. This, effectively, was what the most recent bail-out and debt restructure was all about. Europe has been desperately trying to pretend that a 50 per cent cut on Greek bonds is somehow not a default, but of course in reality it was precisely that.
Now, however, a full-scale disorderly default looks that much more likely.
Few observers thought that Europe’s plan to deal with the debt crisis would be a sustainable solution, but no-one could have predicted how quickly it has unraveled in the face of Papandreou’s gamble. Last month’s crisis summit, led by Merkel and Sarkozy, broke up with an agreement to restructure Greek bonds and recapitalise European banks threatened by the debt restructure.
Longer term, Europe’s leaders decided to pony up a new Europe-wide bail-out fund called the European Financial Stability Facility. The EFSF was planning to take roughly €440 billion in funds pledged by European member nations and leverage it up to a fund roughly €1 trillion in size, by issuing its own bonds against the security of that big pool of money. If this sounds like risky financial alchemy, that’s because it is. One of the ways Europe plans to get out of a debt crisis is to issue more debt.
But all that is on hold, due to the market turbulence in the wake of the announcement of the Greek referendum, with the EFSF postponing a planned bond sale, citing market volatility. The absurdity of the situation was perhaps best expressed by British bond trader Gary Jenkins, of Evolution Securities. "The vehicle that’s supposed to borrow on behalf of countries that can’t borrow, can’t borrow," Jenkins told Bloomberg. "They should be able to tap the market under any market conditions and it should just be a matter of price."
No wonder Angela Merkel and Nicholas Sarkozy are furious. "Does Greece want to remain part of the eurozone or not? That is the question the Greek people must now answer," the German Chancellor told European reporters gathering in Cannes. The referendum announcement precipitated a crisis meeting in Cannes between Merkel, Sarkozy, IMF chief Christine Lagarde and the top brass of the European Union, José Manuel Barroso and Herman Van Rompuy. They appear to have phoned Papandreou and told him they would be withholding any further bail-out payments to Greece until it re-confirmed its commitment to the eurozone.
What a mess. It’s hard to argue with prominent economist Willem Buiter when he writes in the Financial Times that the current crisis will most likely end in a European recession. "Because neither restructuring of insolvent sovereigns, nor recapitalisation of zombie banks, nor ring-fencing of those sovereigns that are mostly likely solvent but vulnerable to illiquidity ambushes have been addressed decisively and completely," he explains, "tight financial conditions and intensifying fiscal austerity will contribute to a European recession in 2012 and possibly beyond."
The Greek referendum will apparently be held on 4 or 5 December. It’s going to be a bumpy ride in world markets until then.
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