NEW YORK (TheStreet) -- Greece had hoped to conclude negotiations with its international creditors by early Tuesday at the latest, as talks continued in Athens on a new multi-billion euro bailout designed to keep the country from financial ruin.
We have reasons to believe why it's in everyone's best interests for Greece's creditor nations to shoulder the bailout.
Let's understand the unfolding events from the current crisis to the possible consequences if the euro were to break down to the solutions that this bailout could provide.
Euro Formation: Systemic Loopholes
When the euro was introduced, currency risk in the eurozone disappeared outright. That made trade much easier because of transparent pricing and no currency conversions. It eased the way for governments and investors to own foreign assets and liabilities in the eurozone without the risk of currency loss. But it also left a major loophole in the system -- member nations having one currency but different country dynamics. To counter that problem, the Maastricht Treaty was signed, with the following requirements:
1. Government budget deficit as proportion of gross domestic product <= 3%
2. Government debt as proportion of GDP <= 60%
3. Inflation of 2%+
4. Bond yields <=6.6%
Over a period of time, however, several countries flouted those requirements. Governments sidestepped best practices and ignored international standards meant to securitize revenue in order to reduce their debts and deficits. Unfortunately, several governments cloaked their deficit and debt levels using a combination of techniques, such as inconsistent accounting, off-balance-sheet transactions, complex currency/credit derivative structures and more.
That all got exposed later when dominoes in the 2008 Wall Street crisis came crashing down on the European financial world.
While the Maastricht Treaty requirements were put in place to ensure the convergence of member nations on fiscal policy, inflation and interest rates, there was no focus on the ability of different countries to compete globally. The peripheral nations such as Greece, Portugal and Spain scored much lower than others such as Germany and France in competitiveness.
The major loophole left the entire platform fragile, because the euro wasn't able to be manipulated to adjust for the difference in the economies of different countries in the eurozone. The difference in competitiveness helped stronger nations to score much higher on quality in the international markets in absence of any independent currency mechanism that could affect their competitiveness in the short term.
The bond yields in peripheral nations -- particularly Italy and Spain -- were slightly higher than they were in the euro core, which attracted a growing number of investors. Without currency risk, it made sense for German, Dutch and other international investors to head south for a warmer return on investment.
Additionally, China's economic expansion enabled the country to have high exports, which increased its current-account surplus and swelled its foreign-exchange reserves. Because the reserves were mostly invested in U.S. dollars, China pushed down the global risk-free rate, thus lowering the yields on other fixed-income assets. That provided a further catalyst for investors in northern Europe to succumb to the debt temptations of southern Europe.
Normally, reckless borrowing would raise interest rates, triggering an automatic brake. But that did not happen, as the interest-rate spreads converged with other nations. As core nations invested their surplus from higher yields into the real-estate markets of the now-troubled nations -- Spain's housing market bubble, for example -- the growing imbalances in the whole eurozone economy were as much a fault of the creditors, which are the core European nations, as that of the debtors, which are the peripheral nations.
Deceptive Eurozone Current Account Balance
The eurozone's stable current-account balance was quite deceptive, as Germany's high current-account surplus was increasingly being offset by peripheral nations' growing current-account deficits. If Germany had a continuous surplus in the absence of the euro, its currency would have appreciated to keep its surplus in check. But with the euro, there was no such immediate impact on currency valuation, and Germany's competitiveness in the international market kept increasing, leading to even more surplus.
On the other hand, for peripheral Europe, a currency devaluation would have lowered the current-account deficit to a large extent. That did not happen, and the deficit of peripheral countries kept increasing. In essence, the increase in peripheral deficit was offset by Germany's surplus, which resulted in a stable current-account balance for the eurozone.
Earlier, if a country had a deficit and was unable to pay its creditors, it could get help from its mint. That would increase the nation's currency supply and lead to the currency's devaluation. The devaluation would have led to foreign creditors' losses, which was precisely the reason loans from peripheral countries had higher interest rates.
With the euro, however, the liberty to print money was absent, and so was the currency risk. In a way, that was like low-risk gold for international investors. They benefited from it tremendously for years, before being stuck in the current situation in which Greece can't repay its debt and can't print the currency, either.
Why Stronger Nations Should Share The Burden?
Since the euro was formed, countries such as Germany and France have benefited from the single stable currency mechanism. They increased their capital-account surplus in the absence of immediate currency appreciation. They earned huge yields by investing in southern Europe, which fueled several asset bubbles. Even after the euro crisis set in, the countries benefited from low bond yields and favorable currency movement, further inflating their current-account balances. The inequalities and inconsistencies within the eurozone made the strong nations stronger and the weak nations weaker.
Germany has one of the lowest borrowing costs in the world with a bond yield of 0.65%, which is lower than the yields in the U.S. and U.K. That seems odd because Germany is the biggest creditor of Greece, whose bonds yield 12.17%, and because Germany would be required to nurse huge losses if Greece defaults.
The eurozone crisis may have hit the periphery, but it has also provided tremendous insulation to the core nations as they have derived huge benefits at the expense of instability elsewhere in the system.
If eurozone nations had their own currencies, they would have been fairly valued based on their current-account balances and, thus, would have been regulated. But a common currency between nations with differences in competitiveness gave stronger nations a tremendous gain at the expense of peripheral nations. As a result, the peripheral nations built up huge debts. With that relationship in mind, it becomes much easier to argue a case in favor of sharing the debt burden.
Creditor nations now want their money back, insisting on austerity plans in debtor nations to reduce government spending and release the money instead to repay debt. But with stringent austerity guidelines, improving Greece's economy will become less viable. Reducing social/pension benefits, increasing taxes and reducing subsidies with high unemployment will lead to more poverty, higher crime rates and, ultimately, a default.
As economist John Maynard Keynes said, "The boom, not the slump, is the right time for austerity."
All the while, Greece is tempted to default, especially with rigid austerity plans that lead to economic pain year after year, making austerity politically and socially unfeasible. In this scenario, a default is enticing, particularly when the creditor nations look as if they may otherwise be able to escape with, perhaps, just a bloody nose.
What Happens If the Euro Breaks Down?
If Greece exits the eurozone and the euro also eventually breaks down with the exit of other troubled members, nations would go back to their individual currency systems. Debtors would be nearly bankrupt, with no financial aid from anywhere. They would be forced to cut expenditures immensely, which would deflate the overall economy.
Lower social spending and subdued economic activity would reduce government revenue and inflate budget deficits.
Without more loans, debtor nations would be forced to resort to multiyear austerity programs. They would rather avoid such austerity, something they've been vocal about in the past. Such forced austerity measures that creditors demand are what made Greece consider exiting the eurozone in the first place.
As an alternative to austerity, debtor countries could print more of their nation' currencies, although that would create inflation that depreciates their own currency, ultimately destroying the value of their domestic savings. That would also spell trouble, as their debt would still be denominated in euros and their declining currencies would never measure up to the required payment levels.
Regular defaults on international debt would further devalue their currency, and bank funding would dry up eventually, leaving the domestic credit system seriously damaged.
Creditor nations would also fare badly, bearing losses on their debt with peripheral nations. Frequent defaults would lead to many banks' bankruptcies that could engulf other industries, as well.
The current-account surpluses of creditor nations would be massively impaired because of an almost negligible demand from peripheral nations. (Most of the exports of creditor nations were to peripheral nations.) Meanwhile, the currencies of creditor nations would appreciate, making those countries less competitive in international markets. Loan defaults coupled with plummeting exports would jeopardize the economies of the creditor nations.
Glimpse of a Grim Future
Greece became the epicenter of Europe's debt crisis, with two bailouts worth $264 billion so far and a third worth 86 billion euros on its way. That deal will be settled by Aug 20. The economy has shrunk by 25% during the last five years. Greece's unemployment rate stands at 25%, and its debt-to-GDP ratio is 170%.
Rather than making its way into the economy, the money pumped into Greece so far has been used to pay international creditors.
The Greek stock market was shut for five weeks and banks for one week amid tight regulations. The stock market was a bloodbath on the first day after it reopened as stocks plunged 30%, which is the maximum drop allowed in one day. On the day banks reopened, thousands of people waited on line outside banks to withdraw their money. Those were two signs of how demoralized investors and citizens are about Greece's long-term viability.
How Does a Bailout Provide a Solution?
If Greece is bailed out this time, it would get much needed breathing room that would allow it to focus on ways to improve its economy under new leadership.
Greece's government has been working on many areas and has been able to expand its economy by 0.8% in last three quarters of 2014. It has also reduced its unit labor costs substantially, increasing the labor cost competitiveness indicator of the economy by over 20% since 2009. These numbers demonstrate the government's commitment to bring the economy back on track.
Greece's current debt structure does have a silver lining: Almost two-thirds of the country's debt, which is now 200 billion euros, is owed to the eurozone bailout fund or other eurozone countries. Greece doesn't have to make any payments on that debt until 2023.
The International Monetary Fund has proposed extending the grace period until 2050. Although Greece's total debt seems big, the government doesn't need to make payments for decades to come. By the time that money is due, the Greek economy could have grown enough that the sum would no longer seem daunting.
Greece, however, does need to pay more than 24 billion euros to the IMF and European Central Bank through the middle of 2018. That remains the last hurdle in Greece's foreseeable future. If that debt can be restructured or refinanced, Greece can very well survive this period, while other eurozone countries continue to focus on growth.
It's Not the End of the Road
Although Greece has come a long way in reforming itself, it's hardly out of the woods. The eurozone will have to endure a long journey fraught with economic strife.
If Greece ends up exiting the eurozone, the same situation would eventually arise in another country, and things will only worsen. Greece is only a tiny part of the eurozone, but it's still a harbinger of how ugly things can get, politically, socially and financially.
After tackling its current debt, Greece will need to enact policies that create jobs, reduce reliance on subsidies and steadily increase GDP. In the meantime, creditor nations should have a more empathic approach, leave political interests aside and keep the eurozone intact for everyone's benefit.
A bailout is the only workable solution.