Policy must change - the Euro-zone is out of time

September 24th 2011: Policy must change - the Euro-zone is out of time

In 1992, the UK lifted interest rates to 15% to keep Sterling within the ERM - the policy failed dramatically within 12 hours. In a time of crisis, governments can reach a point when there is a total disconnect between the administration’s policies, financial markets and the country as a whole. The government pulls the levers of power, but nothing happens as the machinery of office just doesn’t function anymore and there is a total lack of belief. Similarly, if international markets know that policies are basically a sham they simply won’t buy it.

The Greek government insists in public that it is committed to the amended austerity package to ensure that Greece receives the next loan tranche in early October. There may be some people who believe that the current economic plan can succeed, but it will be extremely difficult to find them. There is growing hostility to austerity within the country and the government has no real mandate. The simple truth remains that there is no hope that Greece will be able to repay the debts, especially if the economy is subjected to further recession. Even if the austerity plans are approved in parliament, they will not be carried out.

The key problem is that all the key players know that Greece will default in the end and markets have fully price in a default into the yield structure. Given that this is a known outcome, attempts to delay the inevitable will be increasingly counter-productive, a fact demonstrated very powerfully this week as capital continues to flood out of the financial sector.

The basic plan was to keep Greece afloat and give the Euro-zone enough time to strengthen the banking sector before allowing Greece to secure a bigger debt restructuring by defaulting. Ireland and Portugal would have been seen to be on the road to a sustainable recovery which would have limited the contagion risk. The sharper than expected downturn in the global economy, together with political splits and contradictory policies, have meant that Greece and the Euro-zone have effectively run out of time.

In theory, the IMF-led troika can give a favourable report on Greek austerity plans and allow Greece to receive the next tranche of funds. From the market perspective, this will just delay the inevitable and there will be a further flow of capital out of Greece and the Euro-zone as a whole. Europe desperately needs to secure an inflow of capital and this is not going to happen if political leaders continue to pursue policies that markets and EU governments know are not going to work.

The severe spasms over the past week should be warning enough that the current policies are not sustainable. A time of no-return will be reached very quickly where a break-up of the Euro will be inevitable.

The Euro-zone has reached a point where carrying on with the current set of policies is simply making matters worse. There will be severe banking-sector strains if Greece defaults, but the situation can then be dealt with openly rather than pretending that the current policies will work.

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