Letting it Ride on LTRO

Featured On
Business Insider

It appeared that the brinkmanship tactics had pushed Greece over the edge on Feb 12 as Athens was set ablaze in protest. Now it appears that the European finance ministers are slipping over the edge. Strong doubts remain, and are being expressed, about whether a second aid package is throwing good money after bad.

Currency in Crisis

Papademos has failed to deliver. As former ECB vice president, he was expected to deliver two things: new austerity and implementation. He has, after much fanfare, agreed to the new austerity demands. The rub, according to the creditor nations, is the commitment.

Domestic considerations are blunting the international priorities. When this seemed to be the case in Italy late last year, Germany's Merkel reportedly helped push Berlusconi out. However, it seems more difficult to repeat. It seems European officials would prefer to extend Papademos's term. Samaras has no incentive to agree to postpone elections that he would likely win. Nor can European officials bar Samaras, yet his apparent reservations and desire to modify/renegotiate the agreements cannot but undermine confidence in a government he would lead.

In this environment, creditor nations seem to be making a bet on the LTRO that will provide banks with another large liquidity cushion. It will increase their ability to deal with a shock emanating from Greece, if necessary. Ironically, that may mean that the larger the take down at the Feb 29th LTRO, the more likely European officials will be emboldened vis a vis Greece.

There is plenty of room for policy error. The reasons to fear a Lehman-like event still seem compelling. European officials suggest the problem is the lack of implementation of reform and growth measures in Greece. No doubt there is an element of truth with that assessment.

The problem is that it is incomplete. Part of the problem is that the program is working. Greek unit labor costs are falling. Demand is evaporating. The contraction is deeper than expected and despite optimistic forecasts of growth as soon as 2013, the risks are all on the downside.

The Troika are in Portugal to review their progress. They will likely praise Portugal's efforts. However, it may still miss its debt/GDP targets because of the denominator.

At the end of last year, with little fanfare the IMF cut its expected Spanish output by 5% for 2013. It has been slow to cut Portuguese growth forecasts, but it may have to. Over the past decades, the Spanish and Portuguese GDP are about 98% correlated.

The IMF has noted that if Portugal's GDP disappoints, its debt is not sustainable. This is despite the better debt dynamics than Greece and the greater willingness to adopt structural reforms. While we know that failure in Greece's case is not working, it is not clear that success (in implementation) will yield more fruitful results for investors.

Nor will an exit by Greece solve the underlying problems in the euro zone. Greece is a symptom of the problem but not the cause. The problem is structural. The crisis has interrupted the recycling of the North's surplus to the South in the euro area, though previously European officials assured themselves that imbalances within the euro zone are not significant. If Greece (and other peripheral countries) have an over-valued currency, then surely Germany has an undervalued currency.

Just like there are policies that can duplicate the effect of a devaluation--such as a large increase in the VAT, for example, and a large reduction in cost of labor (including employment taxes)--which appears to be the Troika's agenda, there are policies that can duplicate the effect of an appreciation. With or without Greece in the euro zone, Germany does not seem prepared to take such action.