Endgame (part 1): the cauterisation of Greece

1. Greece is being cauterised. The EU, ECB, and others have prepared the ground for Greece to be detached from the eurozone. It isn’t what they want, but there was profound shock at Papandreou’s use of a referendum threat last autumn. So they have prepared the eurosystem for a Greek exit, that theoretically can be handled by the rest of the eurozone. This has considerably lessened Greece’s bargaining power.

2. It will be up to the people of Greece to decide whether they want the prolonged chronic pain of Troika-led adjustment within the eurozone, or the violent shock of euro exit, savings destruction, and devaluation. Some of this is being played out in the prolonged, delayed political negotiations in Athens right now. Whatever the details, and the vote expected in the next day or two is a knife edge moment. But the real test will be possible elections within weeks, insisted on by Greece’s conservative leader Antonis Samaras.

This is the “yes or no” moment for Greece. This is important for Germany. The eurozone‘s reluctant imperium does not and can not be seen to be dictating terms to the Mediterreanean countries. It will provide some necessary democratic legitimacy and national ownership for what will be awfully painful policies. It’s easy to see why many Greek MPs believe that it is a choice of “die or be killed”, but the real choice is between chronic social economic pain inside the euro, or a heart attack and some of the same outside. A horrible choice. But it is for Greece to make.

3. Greece is now the exception. By far the most significant political policy move last year was Angela Merkel abandoning her insistence on private sector burden-sharing (private sector involvement ie haircuts for the bondholder bankers) for future bailouts. It was an incredible U-turn considering that it was her insistence on exactly this in Deauville in 2010, against the warnings of the ECB, that precipitated both the Irish bailout and the contagion spreading to Italy, and Spain.

4. Commentators fundamentally misunderstand the German approach to high bond yields in the PIIGS and the credit ratings downgrades across the eurozone. These are reported as bad news. The house view in Germany see these factors as good news. Why? Because for a decade they tried to impose budgetary discipline through the Stability and Growth Pact – an abject failure (partly, of course because Germany and France themselves ignored its strictures).

High bond yields and S&P’s credit downgrades are the best Stability Pact, the best stick that Germany could ever hope for. The bond vigilantes were disarmed by the creation of the virtual euro in 1999. In fact, the very high bond yields suffered in Italy, France and Spain are still lower than they were before the euro.

5. Mario Draghi fired the bazooka in December. He did so in a rather cunning way, basically offering 3 years of free money to the financial system. Half a trillion euros was snapped up. The net result has been absolutely massive demand and issuance of Eurozone corporate bonds from Telecoms companies, banks even in the euro periphery (Telefonica etc etc).

A market contact who has studied the bond prospectuses tells me that 90 per cent of this money is being used to pay down bank loans. Some proportion of this is also being used by banks to buy government debt, the so-called “Sarko carry trade”. Banks borrow off the ECB for free to invest in Italian and Spanish debt at high yields. A measure of the success of this is that the ECB has wound down their own purchases of PIIGS debt.

Part 2 of this blog post on Germany’s spread of what it calls “the stability culture” tomorrow.