When Debtor Fatigue meets Creditor Fatigue

The euro has always been a politically driven project, and the inevitable economic fault lines that emerged  as it expanded  have been met with a surprisingly strong will on the part of  member governments to maintain the single currency. That determination has surprised markets and often confounded analysts , although  any decisive political action has often emerged from crisis meetings in the early hours of the morning. Decision making in such an environment raises issues of democratic accountability and  risks serious policy errors ( for example the determination to prevent a sovereign default within the EA) and  post-meeting disagreements on what was actually signed off ( see Ireland’s belief that the ESM would be able to retrospectively recapitalize banks). The euro is also now left with fiscal rules  and constraints which are  both extraordinarily complex and lacking in credibility; no one believes that a euro member will be fined for a breach and the Commission has repeatedly backed down when faced with one of the larger member states, notably France .

In the absence of a fiscal union the euro member states have funded bailouts for sovereigns who have lost market access, first directly (as per the first Greek loan) and then through the EFSF. Initially the loans carried relatively high interest rates ( as a form of punishment for fiscal impropriety) but that soon changed as debt sustainability came to the fore, an issue of particular importance to the IMF, which was brought on board  to help design loan programmes and the incorporated conditions.

The Fund’s modus operandi is to  project what it considers to be a sustainable medium term debt ratio  and then derive the required primary fiscal surplus needed to get to that target, given other assumptions including economic growth. Those assumptions can prove spectatularly wrong , and they did in Greece ; the  negative impact on the economy of the required fiscal contraction was much greater than envisaged (  GDP fell 25%, a depression rather than a short lived recession) and  the  forecast €50bn receipts from privatization failed the matrialise ( the figure to date is around €3bn).

Such programmes also assume that creditor governments can deliver the required primary surpluses, however large and sustained they are deemed to be , and ignores the electorates role. Debtor fatigue can set in. In most  countries that has been confined to  (growing) opposition parties but in Greece resulted in a new government pledging an end to austerity, new loans, a debt write down and ongoing euro membership,

Much of that is not in the gift of the Greek authorities to deliver (who knows what electorates can decide )  and that debtor fatigue is now meeting creditor fatigue, which has not been eased by the unusual negotiating stance adopted by the Hellenic Republic, which some characterise as driven by game-theory and others see as inconsistent and bordering on farce. The creditors are not united, it has to be said, with France notably sympathetic to Greek requests, although most , to date at least, appear willing to see Greece exit the euro, such is the lack of faith in Greece’s ability to deliver reforms or to meet the terms of any new loan. Some of that hostility emanates from other debtor countries fearful of the impact of a perceived Greek success on their own political futures- we are all creditors now, it would seem.

Any new money, should it materialise,  will come from the ESM, and that requires a unanimous decision by the Board of Governors, made up of member states. Consequently  any one country can prevent disbursement. In addition, ESM debtors are required to be in a programme which it is envisaged would involve the IMF, so Greece’s default with the fund poses a difficulty.

The Greek crisis has also highlighted the Lender of Last Resort issue . The ECB is not willing to fulfill that role unconditionally and has limited the amount of emergency liquidity the Central Bank of Greece can provide to its banking system. So the ECB, despite its claims to the contrary, emerges as a key player; its actions put pressure on the Greek government to reach an agreement with the creditors and could be the  catalysts for  Grexit, as the pulling of ELA would require Greece to print its own notes to fund the economy.

The markets have shown little in the way of panic reaction to  the Greek saga  and probably feel that some compromise will emerge to keep Greece in the euro, if only because such last-minute deals have been the norm in recent years. Whatever the outcome the stark emergence of debtor and creditor fatigue into the light is a profound  development , and one which is likely to have significant longer term implications for the euro regardless of any short-term fix.