Wednesday, March 3, 2010

The Merkel plan won't work

Let's assume that Germany and France can cobble together a support package for Greece. A few eurozone governments will direct their state banks (such as KfW) to guarantee Greek government bonds, which would then be AAA and readily marketable. Sort of a Fannie Mae for Greece.

In theory, this will get Greece over the hump and buy time for it to bring its fiscal deficit under control. Then Greece would be able to access the debt markets on its own and maybe even refinance the guaranteed bonds.

I just don't see how this can succeed in the long run.

One, Greece's expense and revenue trajectories are such that only a deep and sustained depression can bring them into balance, which is politically impossible. (Greece will balance its budget only when it can no longer borrow.)

Two, Greece will not be able to return to the private debt markets anytime soon.

Three, this means that the EU (really the EZ) will have to finance not only Greece's deficits into the foreseeable future, but will also have to refinance maturing debt, until finally all of Greece's debt has been guaranteed by the EZ.

Fourth, the political will in Germany to engage in anything like this is very low.

My prediction is this:

The Merkel manoeuvre succeeds in preventing a crisis at this time.

By the fall, it becomes clear that Greece cannot implement an adequate austerity plan to satisfy the markets or the rating agencies.

Rating downgrades render Greek government bonds ineligible for discount at the ECB and toxic in the debt markets.

Europe would then be confronted with the choice of default or full responsibility for Greek finances (and funding needs).

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