Greece needs rescuing from its creditors

When asked about their views on financial support for the near-insolvent Greek government, European voters tend to deliver a clear verdict. A recent poll found that 68 per cent of French people disapprove of their government’s contribution to the latest rescue attempt. Their German neighbours are even less generous, with 80 per cent of respondents opposing further aid to the Mediterranean country. Nevertheless, European leaders agreed a new €109bn bail-out package for Greece in July, the second lifeline in two years. Are Nicholas Sarkozy and Angela Merkel more sympathetic than their electorates?

Unsurprisingly, the answer is a comprehensive no. The French president and the German chancellor know that their countries are bound to the fate of Greece not just by a vague spirit of European solidarity, but by a tangled web of financial linkages.

According to the Bank for International Settlements, French and German banks would be hardest hit by “haircuts” on Greek government bonds. In addition, a complex network of financial bets on a Greek default, known as Credit Default Swaps (CDS), has made it near-impossible to predict where else in the European financial system the fallout from a financial collapse of the country would be felt.

So far Europe’s strategy for dealing with the resulting uncertainty has been to rescue Greece in order to rescue itself. This strategy has had perverse consequences. It has made Greece the target of much Northern scorn, while delivering few tangible benefits to ordinary Greeks. It has also shielded European banks from the consequences of their reckless lending to a profligate government. Most of all, it has missed the root cause of the problem – namely that Europe’s financial system has become so fragile that it cannot stomach losses on Greek sovereign debt amounting to a modest two per cent of the eurozone’s GDP.

In recent weeks, European leaders have finally acknowledged that the European debt crisis is to a large extent a banking crisis. Now, any bold new strategy for Europe should have the following two components.

First, European banks should be required to accumulate larger capital buffers to protect against credit losses. Immediate capital injections out of a common European fund should be made available to those institutions whose solvency is imminently threatened by a possible Greek default. The price of this government support ought to be stricter regulatory supervision, especially – but not exclusively – in the credit default swap (CDS) market.

Second, Greece’s creditors need to accept a reduction in the country’s obligations which would bring them down to manageable levels. This may require a significant decline in the face value of outstanding Greek debt. If no voluntary agreement of sufficient scope can be reached, the Greek government should be allowed to force this debt reduction on its creditors by means of an outright default.

To be sure, Greece would continue to depend on financial support from the rest of Europe for some time. But once this money is no longer used to keep the country artificially solvent, it could at last aid the prolonged and painful structural adjustment which the Greek economy must undergo.