EMU & Greece : A Woody Allen - Groucho Marx Approach

"I would never join a club that would allow a person like me to become a member", dixit Woody Allen (Groucho Marx). Concerning EMU, unfortunately Greece did and unfortunately European politics allowed it. Was there a case for refusal and should we have known better, a posteriori or a priori ? Let the data speak.

When Maastricht was sealed end of 1991, the criteria were clear. A sustainable budgetary path which prescribes a 3% max. deficit, ideally under a golden rule regime implying current revenue covering current expenditure with investment outlays generating the deficit. This 3% would allow debt to stabilize around 60%, taking a 5% constant nominal GDP growth as a given. The 60% level was however quickly softened to "a level that shows continuous trending evidence of decreasing towards 60%", this to allow Italy, Belgium and Greece into the single currency. In the period 1992-1999, we did see a convergence play at work amongst a majority of potential entrants. In fact, when EMU kicked off 01/01/99, the spreads against Germany were in a tight range of 6 bp (Austria), Belgium 15 bp and at the extreme end Ireland with 22 bp. The main question now is : under which conditions did Greece enter the single currency in 1999 ? The following table is quite a surprise...

As you can see, the 10y spread against Germany comes in at a "healthy" 300 basis points. But not only the long end is exuberant, when looking at money market conditions, the spread even touches 800 basis points. Converged and ready to be launched ? Doubtful, and certainly not priced at the time as being investment grade. Nevertheless, they joined the club and the impossible soon was realized : extreme convergence towards levels at which one can seriously question the sound ratio of Mister Market. The following chart tracks the 10y Greek-German spread under the old normal (1999-2008).

The convergence took absurd proportions when early 2005, Greece paid 9 basis points risk premium above German Bund. Absurd because of 2 reasons : Primo, Greece was still rated A2 at the time against Germany AAA. Segundo, there was no real positive outlook and the public debt numbers give plenty of evidence :

The chart above shows that the 1992-1993 recession blew a serious hole in Greek public finances. And once the entry in EMU was sealed, things got worse, the free ride really took off : In the decade 1998-2008, the public debt ratio never fell below the 1998 level. Now was this decade a period of "external factors" magnifying the budgetary problem ? Not really. Primo, Greece real GDP grew above EMU average in the first half of the previous decade. Segundo, and on top of that, their funding conditions on international markets dramatically improved shown by the chart above on Bund spreads. So, under normal circumstances, there would have been plenty of room to improve the budgetary situation. Instead it didn't, on the contrary, it became even worse :

Of course the last 2 charts are based upon the revised numbers from Eurostat, harmonizing for the fact that Goldman and Co advised the Greek government to represent the budgetary facts in a slightly different and more optimistic way. But that in itself gives evidence as well of "malice" and not really acting in the spirit of Maastricht. Again, once safe under the EMU umbrella, the free-ride took bigger and bigger proportions, most likely even banking on the fact of too big to fail or the no-bail-out-clause not being a convincing deterrent.

The current problem however is 3 fold :

1) Even if you do believe in a sudden change of mindset and the best of intentions going forward, the task facing Greece is of a Herculaneum size. And it's very questionable whether it can be fixed by staying in the euro-zone.

2) Politics can only blame themselves for the political move back in 1998. A Greek membership didn't make sense in those days and it doesn't make sense now. Of course a default or Greek exit is a something one wants to avoid by all means : avoiding a domino effect, a second banking catastrophe and above all, a mega political default. Even the testimony last week - "Yes we did now in 2001 that Greece was cooking the books" - is certainly not an argument, nor justification to come to the rescue right now.

3) Apparently a smaller currency zone is not on the current political agenda. Whether politicians like it or not, Mr Market is now pricing a defacto split-up : Only 5 countries manage to stay close to Germany at worse conditions than in 1999, being Netherlands, Finland, France, Luxemburg and Austria at German spreads in the range of 33-50 basis points. Belgium is gently losing touch again (125 bp) while heavy weights Italy and Spain are already priced at respectively at 200 and 275 basis points funding cost above Germany. Portugal, Ireland and Greece come in at respectively 850-900-1400 bp. And these spreads have worsened over the past couple of months despite the "credible" effort of ESFM expansion. It will be interesting to watch how politicians will solve these issues on a supra-national level and whether Mr market can be convinced to return to the old normal, with or without Greece.