Leaders of the euro area’s wealthier nations are increasingly raising a provocative question: Might the common currency now be strong enough to end the bailout agony and let Greece go?
The short answer is no. In fact, the euro area is probably more vulnerable to a Greek disaster than ever.
Until recently, European officials dismissed the idea of Greece leaving the euro as unthinkable. They seemed to recognize that such a move would amount to mutually assured destruction. Aside from the horrendous legal complications, the exit of one country would raise concerns that further departures would tear apart the euro -- a fear that would become self-fulfilling as market turmoil overwhelmed governments’ finances.
Now, officials in Germany and other northern European nations are saying a disorderly Greek default and return to the drachma aren’t so unthinkable after all. Last week, German Finance Minister Wolfgang Schaeuble said the euro area was now better equipped to handle the potential repercussions than before. Luxembourg Finance Minister Luc Frieden also chimed in. Of course, this could all be a bluff, designed to pressure Greek leaders into accepting harsher austerity measures.
Maybe, but such ruminations need to be taken at face value. With Greece’s outlook darkening and everyone suffering from bailout fatigue and political pressures back home, the idea might gain momentum even after the ink on the latest inadequate deal has dried. Finance ministers from all 17 euro-area countries are scheduled to meet today in Brussels to finalize a Greek aid package, after Greece yesterday identified 325 million euros ($427 million) in spending cuts to secure a bailout.
On the surface, Europe is looking more resilient than it did only a few months ago. Business confidence in Germany is on the rise. The European Central Bank has calmed markets by providing nearly 500 billion euros in emergency three-year loans to the region’s banks. Yields on Italian and Spanish bonds have fallen, creating the impression that investors are less concerned about troubles in Greece spreading to those countries.
The improvement, though, is largely cosmetic. The ECB has brought down bond yields by offering banks a no-brainer trade: Buy European government bonds yielding more than 5 percent with money borrowed from the central bank at a rate of 1 percent. The resulting demand from banks has buoyed bond prices and helped Spain and Italy issue more new debt. It also leaves financial institutions -- and the ECB itself -- more exposed to losses in the event of sovereign defaults or renewed market turmoil.
The banks’ exposure wouldn’t necessarily be a problem if overall confidence in financially strapped countries was genuinely recovering. Sadly, that’s not the case. In Italy, capital flight to other European countries is accelerating. At the end of December, the net claims of euro-area central banks on the Bank of Italy stood at nearly 200 billion euros, up from 89 billion euros in October and 19 billion in July. Such liabilities arise when Italians move their money out of the country, or when foreign investors stop putting theirs in.
Either way, the trend reflects just how fragile the euro area has become. If investors and regular account holders already see a difference between a euro deposited in Italy and a euro deposited in Germany, there’s a real danger that Greece’s withdrawal from the common currency would trigger bank runs and freeze government-debt markets. Should an economy as large as Italy, Spain or even France come under attack, the question wouldn’t be whether German taxpayers want to pay for a bailout, as is the case for Greece, but whether they are able to.
Germany itself is increasingly exposed to a Greek exit. As a result of capital inflows -- the mirror image of the movements out of Italy and other struggling countries -- euro area central banks now owe the German central bank nearly 500 billion euros. It’s hard to imagine how Germany would collect those debts from any country that left the common currency. More likely, as French economist Eric Dor of the IESEG School of Management notes in a recent paper, its own taxpayers would be left with the bill.
Avoiding such a dire outcome won’t be easy. European leaders will have to recognize some difficult truths: Greece and Portugal need a lot more debt relief to get their finances and economies on track, banks need to raise hundreds of billions of euros in capital to restore confidence, and only an overwhelming guarantee fund -- more than 3 trillion euros, by our estimate -- will protect solvent governments from speculative attack.
Keeping the euro together will be costly. It will also be a lot cheaper than the alternative.
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