Seekers of silver linings will have noticed one positive outcome from last Monday’s Greek bailout deal: It has managed to survive a week without unravelling. True, the markets haven’t exactly reacted with euphoria to a deal that has supposedly prevented a disorderly default and Greek euro exit. But the fact markets haven’t yet fallen apart is in contrast to previous “make or break” euro deals over the past two years, such as the infamous Deauville summit in 2010, the July 21 deal last year and the disaster at Cannes in October, which only intensified the crisis. If a modest post-deal rise in most major stock markets now constitutes a disappointment, perhaps that counts as a kind of progress.
The lack of enthusiasm from the market is understandable. Huge implementation risks remain. The Greek government has a daunting list of so-called”prior actions” to achieve before it receives the bailout money. There is a non-negligible risk the private sector bondholder debt exchange will fail. National parliaments in Germany, the Netherlands and Finland must approve the deal. Worse, hardly anyone thinks the deal will work: Few believe there is much chance that Greece will hit its target of a debt to GDP ratio of 120.5% by 2020—or that the debt would be sustainable if it did. Most believe further debt relief will be needed, so the prospect of a default and euro exit remains. Given Greece needs trade and investment, if the market thinks the deal can’t work that raises the odds it won’t.
Still, the fact there was any deal is significant—and provides some clues on how the crisis might play out. What is clear is that a number of euro-zone governments now believe Greece should leave the euro zone and many would have been happy to have helped it on its way by pushing it into default last week. On a visit to Germany last week, I was struck by how many people in the country’s financial sector believe the markets could take a Greek euro exit in their stride and believe the euro would be a stronger currency without Greece in it. Many believe last week’s deal is simply designed to buy time, perhaps only until the summer, before Greece is forced out of the euro. German interior minister Hans-Peter Friedrich has said publicly he believes Greece should quit the single currency.
That view is emphatically not shared by the European Central Bank. It believes that pushing Greece into a disorderly default and euro exit would be playing with fire. It fears the uncertainty created by a Greek exit would lead to contagion with other peripheral countries, including Portugal, whose bond yields had been rising in the weeks before the Greek deal, first in line. Ultimately, the ECB’s warnings in the run-up to last week’s summit that if Greece left the euro, others might be forced to do so too, appears to have been decisive, persuading governments to drop their hard-line stance—at least for now.
Indeed, it is hard to overestimate the extent to which the ECB has been able to call the shots over the past two years. Ever since the ECB reluctantly agreed in May 2010 to launch its Securities Markets Program to buy Greek government bonds—ostensibly as a monetary policy operation to lower domestic interest rates—it has been drawn deeper into the crisis. The ECB’s bond-buying has given it the power to dictate policies to member states, blurring the line between fiscal and monetary policy. It has used this power to demand the deep structural reforms and fiscal austerity, most notably when it punished former Italian Prime Minister Silvio Berlusconi’s government for backpedaling on reforms by refusing to buy its bonds, eventually forcing him from office.
At the same time, as concerns over government finances have spread to the banking system, the ECB has also offered banks unlimited liquidity against ever-looser collateral requirements. These Long-Term Refinancing Operations removed the risk of a systemic bank collapse and took some of the pressure off sovereign bonds. But they also allowed the ECB to take over from private markets as the main source of funding of peripheral country current account deficits. This is illustrated in so-called Target 2 balances, which reflect outstanding debts between euro zone national central banks. Germany is currently owed €498 billion ($669.68); under the gold standard, the Bundesbank would have received gold from creditor countries to settle these balances, notes Dr. Jorg Kramer, chief economist of Commerzbank. But in the euro system, it is simply entitled to a share of the peripheral country’s collateral, which is unlikely to be worth much in a euro break-up.
As a result, the bigger the ECB’s balance sheet gets, the more powerful it becomes. The more the ECB intervenes, the bigger the potential exposure of rich countries like Germany if the euro zone collapses. It is gradually becoming clear to member states that it is in their interest to shield the ECB balance sheet from losses. The complexity of Greece’s debt restructuring stems in large part from the need to avoid triggering losses for the ECB that might call into question the credibility of its balance sheet, particularly the €400 billion of bonds it has bought under the SMP. And the euro zone’s decision to keep Greece in the euro largely stems from the fear of how the markets might react if the ECB said it was no longer able to buy bonds and feared it was likely to be hit by other losses.
Of course, there is not much the ECB can do if Greece decides to reject the bailout and leave the euro. But the ECB believes the bailout can be made to work and will continue to push Greece and other euro-zone countries to try to make it work. That may not please national governments, who can feel themselves being sucked deeper into the crisis. But until they can resolve their differences and unite behind a clear political agenda to fix the deficiencies in the euro zone’s economic and monetary union and reduce their reliance on the ECB’s liquidity, they have little choice but to defer to the one European institution that has shown itself able to act in the crisis.
That is, until the ECB’s balance sheet grows so large that its own credibility is called into question. But by then, it may be too late.