The evidence is becoming increasingly clear that German policy makers are prepared for Greece to exit the euro zone. Knowing this changes how one should view the likely policy responses in Europe.
We have had indications of various sorts for some time that Germany is preparing for Greece’s exit from the euro zone. Indications that the Germans wanted to throw the Greeks out of the eurozone began in November. However, with the Greek election having radicalized Greek politics, the Germans are coming out in force talking openly about Greece’s departure from the euro zone.
Now mind you, there is no mechanism to formally eject Greece or any other member. A majority of Greeks want to stay in the euro zone according to polls. And even Greek anti-austerity party Syriza is saying that they want Greece to remain in the euro zone. However, the Germans are having none of it because they fear the consequences of letting Greece flout the agreed to bailout package and austerity plan, believing it would harm their agenda elsewhere in the periphery. The question is what happens next.
I don’t see a Greek departure as imminent. In all likelihood, the Germans are bluffing because a Greek exit would mean enormous damage to the balance sheets of euro banks, particularly in France where exposure to Greece is high. Moreover, a Grexit would embolden other periphery countries by giving them leverage in dealing with the bitter pill of austerity.
What is happening is that the Germans recognize that Greece cannot make the grade and will eventually have to exit the euro zone, the key word being eventually. Germany also recognizes at once that their policy response of limited ECB support for euro zone sovereigns in exchange for austerity and internal devaluation in order to repay bondholders 100 cents on the dollar is unrealistic. The Germans want to force this response in order to entrench German economic orthodoxy of fiscal probity and price stability within the eurozone for fear of the euro turning into a weak currency backed by countries with poor fiscal discipline. So they are playing chicken by acting as if nothing has changed while still ceding ground.
How have the Germans have already ceded ground on fiscal discipline and price stability?:
- Relaxation of 3/60 rules. I indicated early last week that the Maastricht debt/deficit criteria of 3% deficits and 60% debt to GDP are likely to be relaxed. With the Netherlands having problems with deficits, this was the only logical policy response. We are now hearing in the press that the Spanish are going to get a longer time frame to meet the 3% hurdle in exchange for more oversight from the Troika. I don’t know if this validates my view from October that the Troika was going to occupy the periphery but it is certainly looking like this will happen. I should point out that Germany is in violation of the Maastricht 60% debt to GDP hurdle and this is another reason they will cede ground on these issues.
- Inflation target. Everyone is talking about the shift in monetary policy at the ECB. Der Spiegel has written that "a high-ranking official, who did not want to be named, said that the bank was referring to an inflation rate that lay “moderately above” the European Central Bank’s target of just below 2 percent." This tells you that Germany is prepared to allow more inflation in the euro zone to accommodate the periphery going forward, a major concession on the issue of price stability.
That’s where we are so far. But Greece is still a problem for the Germans here as these fixes can help the rest of the periphery, but Greece is clearly out of bounds. By that I mean it will take more than a swag to deal with Greece, either a re-default or euro zone exit. This means that while I think the Germans are bluffing, the Germans are forced to act as if they are willing to let Greece leave the euro zone and plan for that exit in case the situation spirals out of control. The goal that German leaders have already publicly stated is to build a firewall against contagion from a Grexit or Greek re-default.
The biggest consideration at the moment is the Spanish banking sector. And so the EuroTARP idea has developed a lot of momentum behind the scenes. More and more voices are talking about it and it is clear that the idea is being discussed in secret by policy makers. In my view, this is a done deal for Spain. But, if Europe is making contingency plans for a Grexit, then the EuroTARP funds will be used all around since German and French banks would be damaged by even a Greek re-deault, but certainly by a Greek exit.
In addition, European policy makers will want to create specific mechanisms for allowing a departure by changing treaty language. Late last year I talked a bit about this but I think it is more urgent now than ever given what is happening in Greece. I believe the Germans are ambivalent about Greece’s staying in the euro zone because it causes so many problems for the rest of the periphery. However, they recognize that Europe is not ready politically for a Greek exit. The goal is to then set up a framework that fits German orthodoxy and allows for an eventual exit.
The new framework will address the following:
- Fiscal rules that will follow the stability and growth pact guidelines.
- A growth compact that will include countercyclical budgeting from the European Investment Bank (EIB) but also language to adjust labor markets and make structural reforms in line with neoclassical supply side growth orthodoxy, not in line with the Keynesian stimulus growth paradigm being pushed by the likes of Paul Krugman.
- Penalties for not following the rules that will include at a minimum EU/EC fiscal oversight like we see in Greece in order to give teeth to the enhanced stability and growth pact.
- Specific mechanisms for establishing a euro zone exit for persistent violators of the rules.
The overall goal is to accommodate events on the ground within the existing economic policy paradigm by making tweaks here and there. There is no indication that the Germans want to or are prepared to make any fundamental shifts in European economic policy. The goal is to limit the damage caused by Greece, recognizing that Greece will definitely exit the euro zone now or in the future.