The inevitable Greek default will hurt European banks badly. To soften the blow, an unworkable solution has been proposed, which could result in a social catastrophe, argues James Meadway.

EU ministers have delayed payment of an €8bn loan disbursal to Greece after the PASOK government admitted it would not meet deficit targets. Without the money, the Greek state may not be able to pay its workers over the next month.

These targets were set as part of the 21 July deal, in which further bailout cash would be delivered to Greece in return for further austerity measures. In just a few months, it has become clear the plan is failing.

It is failing for two reasons. First, the bailout cash was never intended to help people in Greece. It was intended to ensure Greece can continue meeting repayments on its public debt – not to fund public services or help the economy recovery. It is Greece’s creditors, not Greece, that is being assisted.
Second, the austerity measures demanded have pushed the economy into a deeper and deeper slump. By cutting public spending, austerity has reduced demand inside Greece. Firms sell less. They have cut wages and made redundancies. This, in turn, has further reduced demand, setting in train a vicious circle of decline. The Greek economy is now shrinking by around 7 per cent a year.

The realisation is dawning across Europe that Greece will have no option but to default on its debt. The Greek national debt is currently at 189 per cent of GDP, and interest payments alone are forecast to hit 15 per cent of GDP next year. There is simply no way it can be repaid. Greece will have to default – cancel a major part of its debt.

The bankers’ fear

For the last year, the august international bodies gathered in the Troika – the EU, IMF, and the European Central Bank – have skirted around this issue. Continual bailouts have been paid in the hope that Greece may, by some miracle – it has never been clear what – suddenly find itself solvent. We are reaching the end of the line for their denial of reality.

This is not a Greek problem. The structure of the eurozone laid the foundations for the debt crisis, with massive surpluses in northern Europe recycled as massive debts and deficits to the south. When the financial crash of 2007-9 broke out, pushing up sovereign debts everywhere, the whole uneven structure crumbled, leaving southern countries with unmanageable burdens. But it is Greece that is expected to bear the brunt of the eurzone’s failings. It is not a big enough economy to do so. It will default.

A Greek default carries huge implications. Its creditors will take an enormous hit. French and German banks hold over two-thirds of Greek public debt outside of Greece. Dexia, the part-nationalised French-Belgian bank, is a major creditor. Its share price has collapsed as a result.
There is a substantial danger that these banks, already weakened by the last financial crisis, will become insolvent after default. Further bank bailouts will be required. And since those banks are themselves the debtors of other banks – including in the UK – the whole European banking system could take a hit.

A CDO for Europe

The Troika response is creeping towards an administered default. The 21 per cent “haircut” – reduction in the value of Greek debt – negotiated in July has proved not to be enough. Rumours circulate of a 50 per cent haircut. This will hammer banks across Europe. So to cope with that blow, proposals are being made to hugely expand the European Financial Stability Fund (EFSF). This currently has access to €440bn of pledges from euro members, to be used as bailout loans for other euro member states facing default. It could have its remit widened, to allow it to bail out banks directly.

This huge sum will not be enough to cope, particularly if (as well as banks) large euro members like Italy and Spain are also considered at risk of default. So the EFSF could be expanded – with something around €2tr being the usual figure talked about. None of this money is actual cash sitting in the EFSF account. Instead, the initial pledges to pay will be used to leverage in further money – taking the initial pledges and guarantees, and using them as basis on which to raise more funds from the markets. The theory is that the additional funds can be raised without also creating additional burdens for eurozone members.

To make this financial chicanery work, it has been proposed that the EFSF be turned into the equivalent of the world’s largest Collateralized Debt Obligation. CDOs were the financial devices that allowed banks to treat high-risk subprime mortgage debt as if it were low-risk US government bonds. They were heavily implicated in the financial crash of 2007-8, as the subprime mortgages defaulted and the sophisticated mathematical models used to construct CDOs disastrously unwound.

It beggars belief, but the “solution” offered to the sovereign debt crisis this time is to do exactly what sparked the private debt crisis last time round. The essential problem is the same. You can’t destroy the risk attached to a financial asset without also destroying the asset. You can, at best, shove the risk elsewhere. If the bloated new EFSF is ever actually required to bailout on this eyewatering scale, that would become rapidly apparent. Someone, somewhere, would eventually have to make good on all those promises to pay. That means the individual member states. And they cannot afford – and politically do not want to afford – the burden. As the crisis worsens, spreading from country to country, that burden rises.

The hope is that this won’t be necessary. By announcing a bailout fund of this size it is believed that markets will be calmed, interest rates fall, and sovereign default become unnecessary. But that depends on those in financial markets believing the plan has any credibility. After events of the last few years, that’s highly unlikely over any period of time. All the ballooned EFSF would do, in that case, would be to take the existing debt problem – and magnify it enormously.

The emerging scheme is, at best, wholly unworkable. At worst, it is a social catastrophe in waiting – most obviously for Greece, where a Troika-led default would march hand-in-hand with worsened austerity against Greek society. And it will not be enough. For fear of hurting the banks too much, the scale of the defaults being proposed will still leave Greece with an unbearable burden.

The underlying issue remains. Defaults will be necessary across Europe to destroy the bad debts that accumulated under decades of market-first policies. Current proposals do not destroy enough of that bad debt to prevent it continuing to drag economies down. Austerity must be ended, allowing jobs to be created and some recovery to occur. And to prevent financial chaos engulfing the continent – and beyond – as defaults occur, sharp restrictions will be needed on financial activities. Capital controls, taxes and bans on speculation, perhaps the freezing of delinquent accounts could all be necessary. As the European Conference declaration says, an alternative economic strategy is needed – for workers and society in Europe, against the rule of finance and capital.