Well, punk, do you feel lucky today?

The negotiations for a second bailout of Greece are going to the wire.  Indeed, the goal line seems to be reset further back as some EU countries are wondering whether a Greek default would be less costly than the funds they are supposed to come up with to avoid it.

In retrospect, both the IMF and the Eurozone probably rushed into the first bailout, and the question now is whether they would be throwing good money after bad.

Initially, the ECB committed €45 billion and the IMF together with EU countries and other institutions another €65 billion. In total, €74 billion were disbursed.

What is under consideration now is another €93.7 billion from the EFSF to be applied as follows: €30 billion to help Greece finance part of the private debt restructuring/buyback; €35 billion to help Greece finance the buyback of ECB financing; €5.7 billion to help Greece pay accrued interest; and €23 billion to recapitalize Greek banks.  Net net, the IMF/ECB/EU exposure to Greece would rise to €132.7 billion.

As the clock is about to strike midnight, the wealthier European countries seem to feel like the “punk”, wondering if he should take a chance and reach for his gun, or back off should Dirty Harry have one more bullet in his Magnum .357. “Well, […], do you feel lucky today?”

The key variable in this equation is Italy.  Back in the summer of 2011, markets put Italy and Greece in the same bag, and given the size of the former, a default by the latter would indeed have been very dangerous.  But Italy under Mario Monti has engineered a remarkable reform program, and so far, traditional political parties have cooperated thanks to the Premier’s diplomatic skills (to wit, his handling of the relations with Silvio Berlusconi). 

Spain, the next weakest link, has shown determination in cleaning up its banking system.  Finally, the ECB has hosed the European banks with hundreds of billions of euros, offering three year funding against a relaxed set of eligible collateral.

Confidence in Italy and Spain has increased, bank funding markedly improved.  Do we feel lucky today?  Do we want to face electors and tell them they are on the hook for €100 billion to Greece and counting?  If only we could be sure that Greece would make it.  Alas, that looks very difficult.

Greece would still be highly indebted, and whatever productivity gains it has made look unsustainable.

So far, Greece is experiencing a vicious circle with collapsing demand, investment, employment and tax receipts.  As a result, the fiscal deficit is still growing and the population is revolting.  As I wrote last January in this blog, the risks of political instability are rising in countries under economic stress.  So, further tightening looks counterproductive.

The more serious issues are structural, and therefore do not have short-term solutions.  According to a study published by Natixis, Greek hourly productivity in the manufacturing sector is good, but the value added produced by the manufacturing sector (as a % of GDP) is 40% that of Italy, 30% that of Germany and 26% that of Finland: the manufacturing sector is too small and doesn’t produce enough high value added goods. 

The service sector and particularly the bloated public sector are the real issues.  Yet Greece has done very little to improve this, in particular by going slow on privatizations.  To date, only a few billion euros of publicly-held assets have been sold; this compares with a €50 billion goal and a total base of €300 billion as estimated by former ECB board member Jurgen Stark.

So Greece looks unlikely to be able to grow any time soon.  This makes structural reforms very difficult: privatizations usually result in substantial job cuts, unless the output can be largely increased at a profit.  Think of oil, metals and the like that are sold in US dollars yet produced in devalued local currencies.  This looks unrealistic for Greece; it doesn’t produce these goods and it is in the eurozone.  As to tourism, where the country has both an existing infrastructure and great sites, competing with the likes of Turkey or even Dalmatia looks difficult.

As if it were not enough, ingrained habits, such as skirting the law, operating on a cash basis, avoiding taxes (be they on real estate, income or sales) will be even more difficult to reverse.  They may have had a rational and justifiable basis some time ago, but to the extent they have been absorbed by the culture, they will be that much harder to abandon.

All things considered, the most rational course of action for Greece is to exit the eurozone.  Then, it could follow either one of two models: Russia in 1999 which greatly benefitted from a devaluation of the ruble, political stability and positive economic policies, or Argentina in 2001 which veered to the left and proceeded to distort economic incentives to the point that inflation sky-rocketed, energy surpluses disappeared and the agro-industry declined.

It is also the most rational course for the rest of the eurozone.  Advancing another net €60 billion would achieve little except a short respite, would ratchet up tensions and in the end, destabilize both debtor and creditor countries.

Such a decision would probably cause volatility in the markets, but that could be countered by having the ECB stand behind the sovereign debt of the remaining eurozone members, and by having the latter to commit to better economic policies.