Eurozone default is not synonymous with breakup

Implicit in my post explaining that Germany is preparing for Greek bankruptcy is the view amongst European policy makers that default does not equal euro zone exit. I think I should reiterate this because a lot of people are acting like an imminent Greece exit from the euro zone is likely. This is not the case. Witness these remarks from the German Chancellor Angela Merkel (CDU) and her Economy Minister Philipp Roesler (FDP):

Mrs Merkel told the RBB radio station: "The top priority is to avoid an uncontrolled insolvency, because that would not just affect Greece, and the danger that it hits everyone – or at least several countries – is very big.

"I have made my position very clear that everything must be done to keep the eurozone together politically. Because we would soon have a domino effect," said the chancellor.

At the weekend from German Economy Minister Philipp Roesler suggested that Greece would need an "orderly default" on its debts, a comment that sent global share prices tumbling on Monday.

Here’s what they are saying: The German economy is doing reasonably well. But markets are tumbling and business and consumer confidence with it. Our recent election losses are due in large part to this. And indeed, all of this is due to the bailout policy we have taken since the European sovereign debt crisis began. We intend to put a line under that policy.

This extend and pretend strategy at first refused to concede what was plain to all, that Greece could not repay its debts. In July, we decided to move to the soft restructuring approach of maturity extension and interest rate reduction in order to allow our own banks more time to deal with their exposure to Greece.

This plan has not worked. Spain and Italy, large and relatively core members of the single currency, are now in the spotlight. I have made my position very clear that everything must be done to keep the eurozone together politically because we would soon have a domino effect. The increasing interest rates there risks everything and the whole thing could come unstuck. We do not want this because Germany will be blamed for all of this. And as ‘anti-European’ as our government may sound, this is just rhetoric for the masses which are angry that Germany is again being made to take the lion’s share of burden-sharing. The reality is that we in the German government are still very much behind the European project – not at any cost, mind you; but still we are willing to bear our fair share of the burdens to see this through.

In light of Greece’s inability to meet its austerity targets, we now believe that we must move to a hard restructuring of Greek debt, an orderly default that will also involve recapitalisation of banks in Greece, and some in Germany and elsewhere. Finance Minister Schaeuble is already making preparations for this eventuality. The top priority is to avoid an uncontrolled insolvency, because that would not just affect Greece, and the danger that it hits everyone – or at least several countries – is very big.

Euro zone default is not synonymous with breakup.

  1. Dave Holden says

    I’m unclear on what makes a default orderly vs disorderly. Is it just doing what is necessary to prevent contagion?

    1. Edward Harrison says

      Disorderly is unplanned and unilateral. Think Lehman. Orderly is planned. Think Fannie and Freddie. In the end, Fannie and Freddie were a weigh station on the road to Lehman. So unless the Europeans take the necessary measures to ensure a stable euro (i.e. more fiscal union) there won’t be much difference down the line.

      1. Dave Holden says

        Thanks Edward.

  2. Diego Méndez says

    Sorry, Ed, I cannot get you this time.

    An orderly default would imply Germans recapitalizing the Greek banking system, as well as those core-European banks holding Greek debt.

    Unless they would put most of the burden on banks’ stockholders and creditors (which could potentially create a creditor run), the so-called “orderly default” is tantamount to a bailout.

    So I cannot see how this changes the situation in any sense. Of course you can bail Greece out and that’s probably the reasonable way to go, but you are only buying some months’ time. Spain and Italy won’t be bailed out, so a default could only be disorderly, i.e. a eurozone breakup.

    Or didn’t I get your point?

    1. Edward Harrison says

      First, I am telling you what policy makers think, not what I believe. Second, it is not true that an orderly default is a bailout. Default is default and some of the Germans have been saying all along they want to see banks take haircuts. That moment has come. Whether this ‘orderly’ default stops contagion is a separate issue. I don’t believe it will.

      1. Diego Méndez says

        I see. Thanks for your explanations.

        I agree policy makers may have a default with no euro exit in mind. However, I also think that would lead either to a hidden bailout (banks’ creditors getting no haircuts) or to a euro breakup in a matter of days (contagion via frightened creditors and sudden stop).

        So if they’re not synonimous, they’re pretty similar if you agree that the scale of losses is far bigger than European banks’ current capital.

        1. Edward Harrison says

          I don’t see the breakup happening that quickly. Policy makers have a lot of ways to continue the ball rolling. They can recapitalise banks first and foremost. This may be costly, but thy could just start with the most undercapitalised and say they’re done. Then the markets might calm down and later we see more banks running into problems, etc. On Spain and Italy, the ECB will do their part – how much is the question and using what kind of quid pro quo. The bottom line is that Armageddon doesn’t happen overnight. There are a lot of missteps that get you from here to there.

          1. Diego Méndez says

            Thanks, now I can understand you better.

  3. Jeremy says

    Thank you for your comment. This is the obvious way forward and one missed by so many forecasters who seem determined to project the end of the Euro. (The euro may end but Anglo-Saxon commentators tend to underestimate both the power of governments versus markets and the commitment in Europe to the Euro.) It should however be perfectly possible for Greece to default but remain in the Euro. It will require re-capitalisation of the Greek banking sector and a number of European banks but again this is not impossible. Indeed, as Rogoff and Reinhart have stressed default happens frequently. From a Greek perspective it must be preferable than many years of declining GNP and cuts following cuts in a forlorn attempt to balance the books. Yes it may lead to a domino effect and Italy may also have to restructure debt (perhaps not Spain and Italy whose governments have been far more robust in facing their deficit problems?) Still, this is not the end of the euro although clearly refinancing the banks will cause problems for German, France etc. However, once banking systems have been re-capitalised, recovery may be much faster than expected. This must be preferable to years of cut-backs , austerity and final default in five years time. In this scenario the political damage of depression may well mean the end of the Euro. True defenders of the Euro should be urging Greece to face reality sooner.

    1. Edward Harrison says

      I agree Jeremy. Default is a good thing. The reason this site is called credit writedowns owes to my belief that writing down credit losses is key to recovery from a credit crisis. Delaying these writedowns causes contagion , making the crisis bigger and creating dead weight losses economically and politically.

    2. Dave Holden says

      I agree with this, but it still leaves the problem of finding a political solution to the economic problem of a monetary union that has no fiscal union. The politics having been made worse by perceived “bailouts” from creditor nations.

      That said if recovery results they’ll at least have jumped from the frying pan into the poaching pan.

  4. Jose says

    Seems to me there are still 2 key questions to consider:

    1. If Greece is allowed to default, why should Ireland and Portugal be required to honour their obligations in full? Will their electorates accept being treated in a different manner compared to Greece?

    2. After defaulting, Greece will still have an annual current account deficit of about 9% of GDP. The sectoral balances approach tells us that this will feed into either private sector deficits or government sector deficits – or both. Inside the euro, Greece cannot depreciate to restore its competitiveness. So debt will pile up again, as it did since the start of the euro project. How is this problem going to be addressed?

  5. David Lazarus says

    I do not see default meaning an exit to the eurozone. That creates political issues. Unless an orderly solution is found in the next few days a disorderly solution will the only result.

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