Why Greece will be cut loose

From FT.com today:

European leaders are for the first time prepared to accept that Athens should default on some of its bonds as part of a new bail-out plan for Greece that would put the country’s overall debt levels on a sustainable footing.

The new strategy, to be discussed at a Brussels meeting of eurozone finance ministers on Monday, could also include new concessions by Greece’s European lenders to reduce Athens’ debt, such as further lowering interest rates on bail-out loans and a broad-based bond buyback programme. It also marks the possible abandonment of a French-backed plan for banks to roll-over their Greek debt.

Here’s why the EU is doing this via my translation of an article in German daily Die Welt:

The European Central Bank (ECB) is calling for a fundamental reform of crisis politics in the euro countries. The euro rescue funds have to be increased significantly, possibly even doubled to 1.5 trillion euros. Otherwise the current crisis in the EU bond markets threatens to spiral out of control. This is what Die Welt Online has learned via high-ranking figures in central bank circles.

"The poor crisis management of European governments has ensured that the costs of rescue constantly increase," said one European central banker, who declined to be named. "The existing rescue fund in Europe is not enough to build a credible protective wall around Italy. It was never designed for that."

–Sources: Euro bailout package must be doubled for Italy

As I said when discussing “The political economy of the European sovereign debt crisis”

Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:

• the people in the periphery countries rise up and overthrow the existing order forcing a default;
• the poor economy that austerity entails forces leaders to move to the hard restructuring route as fiscal consolidation fails
• markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
• popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default

Now that Italian bonds are getting crushed and contagion is clearly spreading to the core, Greece will have to be cut loose. It’s only a matter of time.

To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster. At the end of the day, what people want to know is who is insolvent and who isn’t. Once they know, they can fight over who takes the losses. And those creditors that cannot take the losses will have to be recapitalised or resolved. Everyone else gets to live another day.

–Stuffing bondholders in Greece and Ireland