The Greek Conundrum

The participating states established a common central bank, but they explicitly refused to surrender the right to tax their citizens to a common authority. This principle was enshrined in Article 125 of the Maastricht Treaty, which has since been rigorously interpreted by the German constitutional court.

The principle, however, is patently flawed. A fully-fledged currency requires both a central bank and a treasury. The treasury need not be used to tax citizens on an everyday basis, but it needs to be available in times of crisis. When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a treasury can deal with problems of solvency. This is a well-known fact that should have been clear to everyone involved in the euro’s creation. Issing admits that he was among those who believed that “starting monetary union without having established a political union was putting the cart before the horse.”

The European Union was brought into existence step-by-step by putting the cart before the horse: setting limited but politically attainable targets and timetables, knowing full well that they would not be sufficient, and thus that further steps would be required in due course. But, for various reasons, the process gradually ground to a halt. The EU is now largely frozen in its current shape.

The same applies to the euro. The crash of 2008 revealed the flaw in the euro’s construction, as each member country had to rescue its own banking system instead of doing it jointly. The Greek debt crisis brought matters to a climax. If member countries cannot take the next steps forward, the euro may fall apart, with adverse consequences for the EU.

The original construction of the euro postulated that each member would abide by the limits set by the Maastricht Treaty. But previous Greek governments egregiously violated those limits. The Papandreou government, elected in October 2009 with a mandate to clean house, revealed that the budget deficit reached 12.7% of GDP in 2009, shocking both the European authorities and the markets.

The European authorities accepted a plan that would reduce the deficit gradually, but the markets were not reassured. The risk premium on Greek government bonds continues to hover around three percentage points, depriving Greece of much of the benefit of euro membership – namely, being able to refinance government bonds at the official discount rate.

With the risk premium at current levels, there is a real danger that Greece may not be able to extricate itself from its predicament, regardless of what it does, because further budget cuts would further depress economic activity, reducing tax revenues and worsening the debt-to-GDP ratio. Given that danger, the risk premium will not revert to its previous level in the absence of outside assistance.

The situation is aggravated by the market in credit default swaps, which is biased in favor of those who speculate on failure. Being long CDS, the risk automatically declines if they are wrong. This is the exact opposite of short-selling in equity markets, where being wrong means that the risk automatically increases.

Recognizing the need, the last Ecofin meeting has, for the first time, committed itself “to safeguard financial stability in the euro area as a whole.” But Ecofin has not yet found the mechanism for doing so, because the current institutional arrangements do not provide one – although the Lisbon Treaty establishes a legal basis for it.

The most effective solution would be to issue jointly and separately guaranteed eurobonds to refinance, say, 75% of the maturing debt, as long as Greece meets its agreed-upon targets, leaving Greece to finance the rest of its needs as best it can. This would significantly reduce the cost of financing, and it would be the equivalent of the IMF disbursing its loans in tranches as long as conditions are met.

But this is politically impossible at present, because Germany is adamantly opposed to serving as the deep pocket for its profligate partners. Therefore, makeshift arrangements will have to be found.

The Papandreou government is determined to do whatever is necessary to correct the abuses of the past, and it enjoys a remarkable degree of public support. There have been mass protests and resistance from the old guard of the governing party, but the general public seems ready to accept austerity as long as it sees progress in correcting budgetary abuses – and there are plenty of abuses to allow progress.

So makeshift assistance will be sufficient to allow Greece to succeed, but that leaves Spain, Italy, Portugal, and Ireland. Together they constitute too large a portion of the euro zone to be helped out by makeshift arrangements. The survival of Greece still leaves the future of the euro in question. Even if the EU handles the current crisis, what about the next one?

It is clear what is needed: more intrusive monitoring and institutional arrangements for conditional assistance. Moreover, a well-organized eurobond market would be desirable. The question is whether the political will to take these steps can be generated.

George Soros is Chairman of Soros Fund Management and of the Open Society Institute.