International Economic Consequences of the Greek Debt Bailout

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The Greek debt crisis is both a significant economic event and a foreign policy success for Germany. It has, for the present, shifted the economic balance of power in Europe, and to some extent more widely, in Germany’s favour and against those in the US and Britain who do not favour the Euro and prefer a weak European Union (EU). These aspects are interlinked and both worth analysing.

Economics of the Greek bailout

At the economic level the media has widely and correctly reported that the new Greek bailout agreement was a step in the direction of European economic integration. It was also a move towards dealing with some of the contradictions that have existed in the Euro since its creation – as analysed below. Most immediately the partial Greek debt default, writing down the value of its bonds by 21 per cent, together with reducing its interest rate on bailout loans from 5.5 per cent to 3.5 per cent, extendingthe existing repayment period from seven to a minimum of fifteen years, generating debt relief of $19.4 billion or about a quarter of the total, all in the context of an overall $157 billion bailout package, should allow short term stabilization of Greece’s financial situation.

Nevertheless key economic issues remain unresolved. Greece’s debt still stands at 150 per cent of GDP. The 21 per cent write down of its bonds is far less than the 40 per cent by which they were being discounted by the market – an explicit indication the write off may be insufficiently large to generate medium/long term Greek financial stability. The European Financial Stability Facility (EFSF) has not been increased in size to deal with its new obligations. The declaration that this bailout package applies only to Greece is purely words. Despite Ireland and Portugal having had interest rate on bailout funds reduced to 3.5 per cent one or either is likely to enter a new crisis – and the interest rate reduction is already a partial extension of the terms of the Greek bailout.

Most fundamentally the Euro still contains a central contradiction as long as a united European state does not accompany European monetary union. A currency union, such as the Eurozone, means the effects of inevitable changes in relative regional productivity, and therefore costs of production, which take place in a continental scale economy can no longer be dealt with, as in Europe’s past, by changes in exchange rates. Those parts of Europe’s economy with relatively low productivity, such as Greece, will inevitably become increasingly uncompetitive compared to economies with higher rates of productivity and productivity growth such as Germany, France or Holland. This will push the weaker states towards economic depression and social crisis.

In a unified state covering a continental scale economy, such as in the US or China, the resulting problems can be dealt with by budget transfers from richer regions to poorer ones. But this in turn is possible because the largest part of taxation goes to the central government which can then redistribute it between regions.

However, in Europe the central EU budget is small compared to the national budgets. Therefore insufficient resources for such redistributive policies exist. The main European governments remain opposed to any EU budget adequate for such transfers. As the Financial Times cited the currentposition of Angel Merkel: ‘As for a “transfer union”, if it meant paying for other people’s debts, “my conviction is that it will never happen”.’

Of course Chancellor Merkel’s position need not be taken totally at face value – probably a year ago she would have said that the present degree of partial integration arrived at by the Eurozone was also out of the question. But nevertheless a fully-fledged fiscally federated Eurozone is not politically on the cards at present.

Short term trends

This fundamental contradiction at the heart of the Euro, however, need not explode in the short term. If significant European economic growth can be resumed then the resources will be generated to make adequate transfers to save the financial systems of countries such as Greece and to prevent an uncontrollable financial meltdown in major economies such as Italy or Spain. The time thereby gained can potentially be used to shift European institutions, and possibly public opinion, in favour of greater European integration. But the problem is that at present vigorous European growth appears unlikely – a group of economies around Germany and France are growing rapidly, but Europe as a whole remains bogged down by the low growth of the UK, Italy and Spain.

German economic gains from the Euro

The core to the agreement on Greece, and coming events, is that during a difficult period in the European economy German business gains greatly from the Euro. The Eurozone countries cannot carry out competitive devaluations against Germany – and Germany’s economic strength means it can out-compete the other main European economies. Furthermore, whatever the financial transfers required to countries such as Greece, Germany actually gains in exchange rate terms from its association with weaker economies – as these drag down the Euro’s exchange rate. At the time of writing the exchange rate of the Euro against the dollar is 1.44. However without the weaker currencies, that is if Germany was alone, it would face a significantly higher exchange rate, harming German exports.

Naturally Germany suffers some disadvantages – for example transfers to Greece to help pay interest on the latter’s debts, and higher German bond yields, that is higher German interest rates, because of its links to weaker currencies. These drawbacks have led to some leaders of German institutions, as well as large sections of the public, expressing reservations about the deal. These include Jens Weidmann, president of the German Central Bank who stated: ‘By transferring sizeable additional risks to aid-granting countries and their taxpayers, the euro area made a big step toward a collectivisation of risks in cases of unsolid public finances and economic mistakes… That’s weakening the foundations of a monetary union founded on fiscal self-responsibility. In future, it will be even more difficult to maintain incentives for solid fiscal policies.’ Also critical of the deal was the influential Ifo think tank.

But these drawbacks are judged by German business to be smaller than the gains – and believing one can have a policy which only has upsides and no downside is entirely unrealistic – hence the necessity to make compromises provided essential German interests are maintained.

Some opponents of the Euro hope that the electorate of Germany will overturn it under the impact of events such as the deal on Greece. Edmund Conway in the British Daily Telegraph for example analysed: ‘At some point the Germans will realise that the package is a thinly-veiled fiscal union which makes the transfers they funnelled into East Germany look like small change, and they will revolt at the ballot boxes.’

But this is naive nonsense. It is a cardinal principle for arriving at an accurate prediction of the economic course of a country to understand that this will be determined, on central matters, by the interests of big business and not the opinions of the electorate – sentimental analysis to the contrary leads to wrong predictions. German big business has an interest in the Euro and for that reason all major political parties in Germany support it. Therefore, in the end, the key measures to support the Euro will be taken. Even if the Social Democrats returned to power in Germany they would follow essentially the same policies on this issue as Angela Merkel. Only fringe German parties, with no chance of coming to power, oppose the Euro and therefore the policies necessary to sustain it. A few concessions to public opinion may therefore be made round the edges, but there will be no electoral revolt in Germany which will overturn the Euro.

Political dimension

The international political dimension of the Greek bailout is linked to these steps taken to maintain the Euro.

The Euro is today the main alternative reserve currency to the dollar. The fact that the Euro’s exchange rate has risen even more strongly against the dollar since 2000 than alternative potential reserve currencies, such as Japan’s yen or China’s RMB, has increased its attractiveness to both Central Banks and private investors – see Figure 1. While in the future China’s RMB is more solidly based as an alternative to the dollar than the Euro, because of China’s economic dynamism and because unlike the Euro it is backed by a united state, nevertheless immediately China’s economy is still too small, and the convertibility of the RMB too limited, for it to function as a real reserve currency alternative to the dollar. In the immediate situation it is therefore the Euro, not the RMB, which is the real alternative reserve currency to the dollar.

Figure 1

11 07 25 Exchange Rates

The decline of the position of the dollar as a reserve currency is slow. As a percentage of allocated foreign exchange reserves for all countries, holdings of dollars have fallen from 71.2 per cent in the first quarter of 1999 to 60.7 per cent in the latest available data from the IMF for the 1st quarter of 2011 – see Figure 2. The percentage of allocated world reserves held in euros rose from 18.1 per cent to 26.6 per cent in the same period – no other currency has even a five per cent share.

Figure 2

11 07 24 Foreign Exchange Reserves

However while the decline in the position of the dollar is slow it is clear. Given that the position of the dollar as the effective world reserve currency is one of the fundamentals of the economic position of the US, and of its current economic policies, therefore how to deal with the the Euro is a key issue for US economic policy.

US-European political relations

To the economic challenge constituted by the Euro to the dollar was added in 2003 a political issue between the major European states and the US. France and Russia, supported by Germany, made it clear they would veto in the UN any resolution supporting the invasion of Iraq by the US. Subsequent events showed that the European states stance that this invasion was a major miscalculation was correct – and the new US president Obama had himself opposed the war. But US administrations are accustomed to automatic support from Europe for their foreign policy. ‘Neo-con’ circles in the US were therefore determined to secure renewed European support for whatever foreign policy the US adopted.

Important successes in this goal were subsequently gained by Sarkozy being elected President of France – Sarkozy including in his platform a pledge of a new closer relation of France with the US and he has carried out full French re-entry into NATO. In Germany the Social Democrat led government, which had opposed the Iraq war, was replaced by the Christian Democrat led coalition under Merkel. Both events were seen as important US foreign policy successes by neo-con viewpoints.

These successes also allowed the British Conservative Party which, apart from partial independence for a short episode under Edward Heath, has always reflected US foreign policy in Europe to play an aggressive role in rallying forces opposed to deeper European integration. The Conservatives withdrew from the main centre right grouping in the European parliament, on the grounds it was ‘Euro-Federalist’ – and to do this were prepared to align themselves with various unsavoury xenophobic parties in eastern Europe. US policy simultaneously stressed relations with the ‘new Europe’, centred on Poland and other East European states – which were seen as more supportive of United States foreign policy.

Impact of the international financial crisis

The impact of the 2008 financial crisis, and the successive European debt crises, has shaken up this situation. It became clear to the German government, after some initial prevarication, that either greater steps would have to be taken towards greater European economic and fiscal integration or the Euro would unravel thereby greatly harming German economic interests. Germany also had the economic weight within Europe to impose its solution provided it had the will – which is what Chancellor Merkel chose to deploy.

The final terms of the Greek bailout therefore corresponded, in its key terms, to conditions laid down by Merkel in order to safeguard German business interests. There was a private sector write down, in the form of a partial Greek default in order to lessen the burden falling on the German taxpayer, contrary to the earlier declarations of European Central Bank head Trichet. Contrary to the proposals of Sarkozy no European bank tax was introduced.

Furthermore by forcing through a deal consolidating the Euro Merkel also called the bluff of, and defeated, the British Tory Party. The Conservatives were faced with the reality that a deep crisis or collapse of the Euro, with its side effects, would create such international financial dislocation that it threatened to bring down the already weakened big British banks, with consequent worsening of Britain’s already weak economic position, and that the only way to prevent such a crisis of the Euro was to move towards greater integration in Europe. Therefore the Conservatives, previously bitter opponents of deeper European integration, suddenly became favourable to fiscal union in the Eurozone.

As the Financial Times noted:

‘The chancellor [George Osborne]… was “very ­worried” about the possibility of the eurozone crisis spiralling out of control, warning that it posed an additional threat to Britain’s already “tough” economic situation.

‘”We see the potential for a set of economic events that could be as damaging as 2008,” he said…

‘The chancellor was optimistic that the eurogroup of finance ministers would make progress with involving the private sector in reducing Greece’s debts but said this was only the first step towards a necessary fiscal union in the single currency area.

‘He recognised that his enthusiasm for greater eurozone integration turned British policy on its head… He said “the remorseless logic” of monetary union was greater fiscal union…

‘Mr Osborne… called for greater economic integration of the single currency area, adding that the idea of eurozone bonds was “worthy of serious consideration”…

‘Core eurozone countries, such as Germany, would have to stand behind southern European sovereign debt as guarantors, while the periphery would have to accept German-designed economic policy in return.’

The British government then de facto fell into line with the German imposed settlement for Greece byreducing the interest rate on Britain’s loan to Ireland to 3.5 per cent – in line with the policy of the eurozone countries. The cost to the British Exchequer of this step was up to £400 million ($650 million).

Germany looks east

The ability of Germany’s government to determine the essential conditions for a Greek bailout also comes at a time when Germany has been pursuing a more independent economic policy with important success – Germany has become the first major European economy to regain its pre-crisis level of GDP, and from 2010 onwards it began to enjoy rapid economic growth.

To pursue this policy Germany has sought closer relations with China – German exports to China are now greater than to the US, which has meant Germany not significantly supporting US demands that China increase the RMBs exchange rate. The German government has also sought good relations with Russia – although it has also tried to interfere in Russia’s internal affairs by de facto urging President Medvedev to stand for another term as president rather than Vladimir Putin.

Germany has also declined to participate in the NATO military action in Libya, although it has provided limited financial support for the opposition to Gadaffi. This reflects that Germany does not wish to impose an economic burden on itself through higher military expenditure and because Chancellor Merkel knew she had to push through unpopular policies to bail out Greece and did not want simultaneously to face opposition from a German peace movement.

On both economic and political issues, therefore, Germany has taken a position more independent from the US – and this policy has been accompanied by economic success.

Therefore while media attention has focussed on Chancellor Merkel’s short term success in forcing through a private sector 21 per cent debt write down for Greece much more important was the strategic decision taken by, and victory gained, by Germany – which reflected rather broad policy issues.

While Germany’s current policies have brought it economic success, when pursuing a course relatively independent of US administration policy, it is inevitable that there will be a new attempmt by neo-con circles in the US aimed at subordinating German economic policy to US interests and policies. It will be interesting to see what occurs with this.

China and the US

As would be anticipated from the above the steps towards at least immediate stabilisation of the Euro constituted by the bailout for Greece were not welcomed by neo-con circles who fear for the dominance of the dollar. The Wall Street Journal, in particular, carried a whole series of negative assessments of the Greek bailout. This paralleled similar positions among Eurosceptics in the UK – who were critical of the new stance taken by the Conservative Party leadership.

China, on the contrary, strongly welcomed the consolidation of the Euro. Its central bank governor Zhou Xiaochuan issued a statement declaring: ‘This will help in promoting a resolution of the Eurozone sovereign debt issues, maintaining financial stability in the Eurozone and its member states, and maintaining market confidence.’ He noted: ‘We support the efforts made by the European Union and the Eurozone in combating the global financial crisis and improving their fiscal situation.’ Also he noted: ‘China has always been confident regarding the Eurozone and the euro and will continue to play an active and stable role in the international financial market.’ China is clearly far more supportive of the Euro than many circles in the US.

In short the measures taken around the Euro are far from purely a European matter. They affect the interrelation of Europe, the US and China – the three greatest economic powers in the world. Within that framework Germany has gained a notable foreign policy success. The events round Greece are therefore both a major economic and a political event.


The key internal problems of the Euro exposed by the Greek, Irish and Portugese debt crises are not newly discovered but were analysed in advance by the theoretical views which inform this blog. Anyone interested in a more comprehensive analyses of these may therefore like to read the September 1996 article ‘Fundamental economic implications of a single European currency.’

This article was originally posted on John’s blog Key Trends in the World Economy today. Republished with the kind permission of the author.