Germany is preparing for Greek bankruptcy

The mood in Germany is still about cutting Greece loose to save Italy and Spain. My translation of an excerpt of a German-language article from Spiegel is below (Update 12 Sep – the official translation is now here):

German Finance Minister Wolfgang Schäuble (CDU) is preparing for a bankruptcy in Greece, according to to SPIEGEL sources. Finance ministry officials are playing through all the scenarios which could arise in the event of a default in the country. There are basically two variations of a Greek bust. In the first, the country remains inside the monetary union. In the other, it leaves the Euro currency, and reinstitutes the drachma again. The EFSF, the European rescue fund, plays a key role in the deliberations. It must be be equipped with the new powers which were agreed at the crisis summit in late July as soon as possible.

Two mechanisms are taking center stage in Germany’s deliberations: First, Schäuble’s officials are focused on preventive credit lines aimed at helping countries like Spain or Italy, if investors refuse to lend to them borrow following a Greek insolvency. Banks in many countries in the euro zone could also become dependent on billions from the rescue fund, because they would have to write off their holdings of Greek government bonds. Such consequences can be expected, regardless of whether Greece stays in the euro zone or leaves.

The article goes on to mention that Greece’s Finance Minister has recently announced that the economy is expected to contract by a full 5% instead of 3.8% as assumed during the previous rounds of bailout negotiation. The budget deficit target cannot be met in that case. So clearly, the Germans are now forced to face the prospect of default in Greece.

There are two schools of thought about a Greek default concerning Spain and Italy. Portugal and Ireland are separate less systemic issues. In the one school, contagion increases and Spain and Italy come under pressure. The Germans are making preparations for this eventuality. In the second school of thought, a Greek default lessens pressure on Spain and Italy as Greece is seen as “a special case”.

For example, the Spanish daily El Pais writes (my translation):

The countries of the euro zone breached the deficit limit (3% of GDP) and debt limit (60%) established by the Maastricht Treaty on 137 occasions between 2000 and 2010, according to Eurostat. Germany, the country that now stands as a champion of fiscal discipline, and France exceeded these limits 14 times each, while Spain and Ireland, did so only 4 to 5 times respectively – and never before the recent crisis. The best students were Finland, Luxembourg and Estonia which always complied with the rules.

Greece, however, violated both the deficit and debt limit every year. Also exceeding the maximum public debt limit in the eleven years analyzed by Eurostat (see accompanying table)were Italy, Belgium and Austria. The criterion which limits public deficits to a maximum of 3% was exceeded on 60 occasions. The deficit ceiling is the main criteria agreed in the Stability and Growth Pact (SGP), established in 1997. The SGP was the instrument designed to monitor public finances of the euro zone countries to compensate for the lack of fiscal policy in the euro zone layout.

The primary insinuation of the article is that the Germans are hypocrites in that they were in violation of the SGP repeatedly before the crisis and now they are acting as if they are the paragons of fiscal virtue. This is something I discussed in detail in my May 2010 article “Spain is the perfect example of a country that never should have joined the euro zone.” But the undertone here is also about Greece being a special case, a debtor that was repeatedly in violation of the stability and growth pact which deserves to be treated differently. And, yes, in Germany and the Netherlands, there is a lot more sympathy for Ireland which kept budget discipline pre-crisis and has attempted to take on austerity with zeal post-crisis.

Nevertheless, the question about contagion really hinges on the ECB at this point. The EFSF is too small to deal with either Spain or Italy effectively while they attempt to get back under the 3% hurdle and their bond spreads remain extra-wide. And the ECB is an unreliable provider of liquidity. The resignation of ECB chief economist Juergen Stark tells us that. When I say “the euro zone is coming apart at the seams now”, I mean that political cohesion is all but gone. The policy outlook is extremely volatile as major policy makers in the EU, in member states, and at the ECB have extremely discordant policy messages. Some like the Dutch Prime Minister are openly talking of how to break up the euro.

Let’s go further and talk about ‘openness’ in the context of rising economic nationalism and a double dip recession which strains the fiscal rectitutde of all euro member states. Europe is going to become more conservative, more nationalistic and more xenophobic on European-wide issues like free trade, open borders, and free labour movement. The same is true in the US. As I said in April:

Again, I do appreciate a well-argued case that this is not what is likely to happen. But unless we see a multi-year recovery economy in which the nagging debt and default issues are entirely removed, economic nationalism will return with a vengeance.

In my view that means that the European experiment will be under great stress. The Spanish and the Portuguese or the Irish and the British or the Germans and the Dutch would then feel an affinity for each other that the Greeks and the Germans or the Finnish and the Spanish might not.

What does that mean for policy? It means unilateralism. You see the Danes putting up restrictions on the Schengen agreement. You see the Dutch PM talking about tossing out member countries from the euro zone. And you see lots of western Europeans talking about the ‘coming wave’ of immigration from Bulgaria and Romania with dread.

In a deep downturn, these tensions will boil over and the cohesion cannot last. It’s pure speculation how far the anti-openness wave will proceed. But the minimum I expect is at least 1 or 2 members leaving the eurozone, restrictions on Romanian and Bulgarian workers, and a few more dissenters to Schengen.

Sources

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.