Greek referendum - necessary but risky

Greece announced yesterday that it will hold a referendum regarding the latest bail-out package among its citizens together with a vote of confidence in the parliament. The question asked from the Greeks is whether they want to adopt the latest aid package or not. It is a "yes" or "no" question which makes it a dangerous one. But first I will outline the core of latest bail-out package to Greece:

• 50% write-down of Greek bonds (meaning that current holders of Greek debt will suffer a 50% loss)
• 130 billion euros 
• further austerity measures and reforms including selling of Greek assets, sacking of numerous public workers, raising taxes etc

All this should reduce Greece's debt burden to 120% by 2015. Greece should return to growth from 2013 (its economy will contract about 5,5% this year). 

The announcement was shocking because reforms carried out in Greece are not popular, yet they are important in order to get support from IMF and EU. The reasoning here is that solvent EU members want Greece and other historical big spenders to behave according to rules and promote economic growth. By supporting Greece and other PIIGS (Portugal, Ireland, Italy, Greece, Spain) the EU can push these countries to carry out painful reforms. 

Now Greece has put the latest package to referendum. While it is good for democracy it may not be good for Europe. Recent polls show that majority of Greeks think that bail-outs are bad or probably bad to Greece. This is because there are no people in Greece that aren't in some way affected by reforms and austerity measures. 

"No" in the referendum held would mean that the government would step down and new elections would be held. This would theoretically cause the IMF and EU withhold their support money causing Greece to be unable to pay out salaries for months possibly. Even though I am fairly positive that even then some agreement with EU and IMF would be reached, it will cause panic and market tumble wiping trillions off bank accounts. Would Greece leave the euro then? How would Greece deal with all this euro-nominated debt if their currency would depreciate 50% for example? What would be the effect on Greek economy? Just look at Icelandic example for that matter!

"Yes" in a referendum would be the best outcome of all since the people of Greece would show their support to change what current Greek austerity measures are all about. This would make it easier for the government to carry out reforms and would win the total support of the parliament as well. Let's hope that Greek prime minister Papandreou knows what he is doing. 

What about Maastricht criteria?

Every country part of the eurozone has to fulfill certain economic conditions (referred to as Maastricht criteria). The country that is not obeying these criteria can be punished by the ECB. The criteria go as follows:

1. Price stability. The inflation rate should be no more than 1.5 percentage points above the rate for the three EU countries with the lowest inflation over the previous year; 
2. Budget deficit. This must generally be below 3% of gross domestic product (GDP);
3. Government debt. The national debt should not exceed 60% of GDP, but a country with a higher level of debt can still adopt the euro provided its debt level are falling steadily;
4. Exchange rate. The national currency's exchange rate should have stayed within certain pre-set margins of fluctuation for two years (no re- or devaluation of currency);
5. Interest rates. The long-term rate should be no more than two percentage points above the rate in the three EU countries with the lowest inflation over the previous year;

Maastricht criteria were the reason why my home country Estonia didn't join the euro in 2007 as planned because of the inflation criteria was not fulfilled even though Estonia is fiscally the toughest and best performing country in Europe (Estonia is part of the eurozone from 2011). That's OK because rules are rules... or are they? Greece, Italy and Belgium (the heart of EU - really?) joined the euro even though their debt was exceeding 100% of GDP. Greece was running the biggest budget deficit with one of the highest inflation rates. Check the following graphs.

So far the criteria have been important for countries willing to adopt euro since it's a precondition for joining (this statement is conditional itself as seen from history). For joining countries it is a good motivational exercise to get their finances in order. Once already in the eurozone motivation quickly disappears.

So how should we deal with that? Shall we fine the countries that are not capable of cut their spending (read: living within their means)? That's like asking for money from a beggar so it probably wouldn't work. There are still couple of things that could be tried.

Make it political! The main reason for not cutting spending or increasing spending for politicians is the support of their voters. Political promises can often lead to overspending so there is motivation for politicians to spend more than possible. So why couldn't it be possible to force the government step down if two out of five criteria are broken for example?

Another idea is to keep away the cookies. Today a lot of countries are receiving structural funds and richer countries are participating in other mechanisms like Framework Programme. Would it make sense to cut funding for countries that aren't fulfilling their duties? Since all of the EU countries aren't in the eurozone it would be impossible, but approach as such would serve its course (as can be seen in Greece today).

I would prefer stabilizing the eurozone with political measures which reduces populism, the mother of all wrongdoings. We should remove the motivation to behave badly, fines and nagging doesn't work here!

What happens to a country after leaving the euro?

Who hasn't heard of a populist politician arguing that a country should leave the eurozone and be better off? I've had many discussions on this subject but as long as we don't have a precedent we really don't know what will happen. Anyway we have some calculations by UBS Securities (LINK) and I quote:

Ahead of the German constitutional court ruling on bail outs, we have assessed the cost of countries leaving the Euro. For a weak country the cost is 40%-50% of GDP in the first year. For a strong country like Germany the cost is around 20-25% of GDP.

Economic costs of break-up dramatically exceed the costs of bailing out weaker states. Political costs also need to be considered. Virtually no monetary union has broken up in modern times without some trend to authoritarian or military government, or civil war.

The cause for such a major crash is loss of credibility, default, collapse of banking system etc. I wonder whether the same people arguing against war in Iraq for example are arguing against bailing out countries like Greece which could turn into civil war? I wonder how the protesters below expect governments to fund basic needs of people with a scenario described above?

It is easy to be populist because it is good to be popular. Next time you hear somebody arguing their case about Greece, Italy or Iraq ask them about alternative theories - what should we do then (and don't settle with an answer "don't bail-out a country") - because that's what we usually see and hear - populist thoughts without a credible alternative.

Cat and mouse play by the ECB

I'm back from a nice holiday and sad to see that Greece is making the headlines again together with Italy. Two interesting things have happened that caught my attention.

First, Greece has caused representatives of the IMF (International Monetary Fund), EU (European Union) and the ECB (European Central Bank) to walk away from a progress monitoring event which was suspended for 10 days causing the bond yields of Greek 2-year bonds to rise to more than 50% today! The price of the bond has fallen lower than 50% of its initial value. This means that investors are getting more confident over a Greek default. Greek finance minister Evangelos Venizelos claims that Greece is not willing to make any more budget cuts this year.

The second interesting thing is that at the same time the ECB has not commented on whether they are continuing to buy Italian government bonds or not. This has caused yields of Italian 10-year bonds to rise above 5% again which is considered to be not-sustainable.

The ECB doesn't have too many instruments to put some pressure on Italy and Greece carrying out their austerity programmes. While couple of weeks ago we could see worrying statements by Papandreou, Berlusconi and Tremonti (Italian finance minister) then suddenly we're seeing both governments dropping some of their austerity plans. So right now we might just be seeing the ECB taking a more straightforward line with the two governments.

Even though both sides want to find a solution to the crisis it is not so easy to find it. The economies of both countries aren't doing so well and extra austerity measures might temporarily lower the growth even more. At the same time the ECB has to stand against Germany who opposes bond buying programme. Who will be the cat and who will be the mouse in the end?

Finland vs Greece vs Europe

No, it's not a football match I'm going to write about, even though Greece would have a much bigger chance succeeding there. Finland has gained much attention recently since their prime minister announced that Finland has gotten monetary collateral for supporting Greece. This means that Finland agreed to support the second bail-out package to Greece only if Greece would deposit equal amount of money as a collateral for Finland. If Greece would go bankrupt, Finland would keep the money.

For Finland this is mainly a domestic political campaign. Finnish voters are turning anti-euro and the government had to do something in order to win some votes back. For Greece, guaranteeing collateral was one way of securing the votes of all countries, including Finland.
Other countries in the eurozone though are (rightfully so) upset because if one country gets collateral, why shouldn't others? This would eventually lead to a situation where all the money borrowed to Greece would be deposited somewhere as collateral and there would be no money left for Greece to cover its costs. Is there any solution for this?

Seeking collateral for the money borrowed to Greece would be a good idea since this would discipline Greece as well. What could be used as a collateral though? One possibility could be natural resources. In 1992 my home country Estonia successfully carried out a monetary reform which substituted Russian ruble with Estonian krona. Estonia initially used our national forest and gold reserves as collateral for the krona. So let's look at Greece's natural resources and other reserves (from CIA World Fact Book):

• 991 million cubic meters of natural gas with a market value of around 138 billion USD (Bloomberg)
• 6,37 billion USD in gold reserves
• 10  million barrels of oil with a market value of around with a market value of around 1,1 billion USD (Bloomberg)

In addition to that Greece has deposits of bauxite, asbestos, nickel, magnesite and marble. So Greece just might have enough natural resources to at least partially put out a collateral for money received from other eurozone countries and the IMF. As a matter of fact natural gas, gold and oil reserves add about up to the total amount of the most recent bail-out package of 110 billion euros.