Greece can slay its financial demons – but will it spare the euro?

ΠΗΓΗ: GUARDIAN

by Larry Elliott

There's a scene in The Lord of the Rings where the wizard Gandalf confronts the Balrog, a hellish monster, on a narrow bridge in the Mines of Moria. The battle ends with Gandalf smiting the bridge with his staff, sending the Balrog plunging into a fathomless abyss.

There's a twist to the tail, however. As the monster falls, one last swish of its whip curls round Gandalf's ankle and drags him down into the pit as well. Views may differ, in the context of the eurozone debt crisis, whetherGreece is Gandalf or the Balrog, but one thing is for certain; the risks of mutually assured destruction are high.

Both Greece and the hardline European countries demanding cast-iron assurances that they are not throwing good money after bad in a new €130bn (£108bn) bailout have the potential to shatter what, at best, is a fragile truce. The Greeks might decide they have had a bellyful, and that default and departure from the euro is preferable to endless austerity and the humiliation of colonial status.

The Germans, Austrians, Dutch and Finns could come to the conclusion that Greece is a lost cause, and that nothing politicians in Athens say about their commitment to collecting taxes, cutting spending and reforming the economy can be believed. They might decide, despite all the official statements to the contrary, to chuck Greece out of the single currency.

Although the creditors appear to hold all the trump cards, that is not really the case. Greek politicians can put their signatures to little pieces of paper pledging themselves to stick to the terms of a bailout deal, but once the money has been delivered and elections held, the incoming government could tell the other members of the single currency to take a running jump. Sovereign states – even those as vulnerable as Greece – always have that power.

What's more, the Greeks have the advantage of knowing that a financial crisis precipitated by a messy default would hurt the rest of Europe more than it would hurt them. In Like a Rolling Stone, Bob Dylan sings: "When you've got nothing you've got nothing to lose" – that's a sentiment that resonates with many Greeks.

Dhaval Joshi, of BCA Research, makes an interesting point in this context. There are, he says, traditionally two ways of getting rid of your debts: you can grind them down, little by little, through protracted austerity programmes. Alternatively, you can default, which gets rid of the debt quickly but leads to a much sharper plunge in output.

But for Greece, there is scant difference between the two: it will have a deep v-shaped recession if it defaults but it is having a deep v-shaped recession anyway. And there is not one politician in Athens who believes that sucking a further €3.3bn out of an economy contracting at an annual rate of 7% will do anything other than intensify the slump.

Black hole

Those holding the purse strings are doing their own cost-benefit analysis. Wolfgang Schäuble, Germany's finance minister, summed up the mood when he talked of pouring money down a black hole. If, as the northern European eurozone members clearly believe, Greece will be back for another bailout in the near future, why risk the wrath of their voters by handing over €130bn now?

The assumption is that the European Central Bank has created a firewall by throwing cheap money at commercial banks, and that there would be no repeat of what happened following the collapse of Lehman Brothers in 2008.

This is a very big assumption. The Bank of England certainly does not believe that Greece could be quarantined in the event of a messy default. Nor does Barack Obama, who talks to Angela Merkel at least once a week about the crisis. Nor, in all probability, does the ECB itself, because it appreciates the fragility of many European banks, including some of the biggest names.

It is not enough to know that bank X has a certain quantity of Greek debt on its books, nor even how many credit default swaps it is holding. As Joshi notes, there is also "a large, active market in derivatives of CDS and even derivatives of derivatives. And as these more complex and esoteric instruments are over-the-counter contracts with no central clearing or reconciliation, it is simply not possible to know who holds what gross or net exposure, where they are, and what chain reactions would ensue."

What conclusions can we draw from all this? Firstly, that the laidback approach of the financial markets to Greece looks worryingly complacent. The hardening of the rhetoric last week is possibly more than just sabre-rattling; there was talk last week that Monday's summit will merely provide Greece with a bridging loan to tide it over for the next few weeks. This crisis is approaching its end game, and the chances of events spiralling out of control is much higher than the market bulls imagine.

Secondly, the insults being hurled by both sides hardly foster confidence that the eurozone can survive this crisis in one piece. What we have seen in recent weeks is a growing alienation of voters across Europe from the idea of closer fiscal union, even though closer fiscal union is the only way that the fundamental flaws in monetary union can hope to be remedied. For the Greeks, fiscal union means being bossed around by the Germans; for the Germans it means writing blank cheques to the Greeks. This is not a healthy state of affairs.

Disintegration

Finally, the overt lack of anything that could be remotely described as European solidarity illustrates the unworkability of the "project" and hints at its eventual disintegration. Put simply, monetary union created a common interest rate at a time when inflation levels varied markedly. Some countries – mainly the northern European ones – had inflation rates lower than the level of inflation, so they tended to grow more slowly and have higher levels of saving. Other countries – mainly those on the southern periphery – had negative real interest rates because loan costs were below the inflation rate. They grew quickly and had an incentive to borrow from the savers of northern Europe.

There are only two ways this can end. The weaker countries leave the single currency and run independent monetary policies tailored to their circumstances. Alternatively, they agree to do what Germany and the other northern European countries tell them, in return for substantial fiscal transfers. As things stand, the former looks much more likely.

Those who know their Tolkien will recall that Gandalf finally defeats the Balrog but perishes in the process. He is then reincarnated in a new form. The same fate may await the euro.