The market was very sceptical this past week of the deal to create a fiscal union among eurozone members hatched at the previous week's EU summit. And rightfully so. Creating a new fiscal union outside of the EU framework isn't going to happen overnight. There are a huge number of political and technical obstacles that are going to pop up during the course of 2012 and many opportunities for the deal to be derailed. However, behind the chatter about the new fiscal union was another European story that might have as big of an impact on the final outcome of the crisis: Greece is falling short in its reform efforts and remains a threat to European stability.
Of course, given Greece's short- and long-term track records, it shouldn't be a huge shock that the country is falling behind, but the International Monetary Fund report released last week highlights the gap between the official line on reform and what is actually happening on the ground. The IMF sees a number of problems in Greece. Among them, the economy has taken a turn for the worse and the recessionary woes continue to escalate. Authorities are having trouble implementing the austerity measures that they have already passed, and privatisation plans have been sidelined as market conditions are making it almost impossible to divest of anything even at fire-sale prices. The IMF believes that the new government is committed to following the plan, but so far it isn't working.
In isolation, this shouldn't cause too many waves in Europe. Greece is a small economy, and it could keep getting bailed out by the rest of Europe as long as everyone else stays above water. However, the problems that Greece is facing implementing its rescue package now could be a canary in the coal mine for the rest of Europe. There are a few ways in which a further escalation in problems in Greece could continue to have a serious impact on Europe and the world.
Greece as a Model?
Time and time again, European leaders have said that their actions in Greece shouldn't be seen as a special case. In some ways they are right. Greece's debt load is high even by European standards, and its economy is much less competitive than those of other eurozone nations. But even if the scale of change is bigger, Greece's bailout was supposed to serve as template for how to deal with economies on the brink. The plan involved short-term infusions of liquidity, voluntary bond write-downs, and severe austerity measures.
Unfortunately, this plan isn't really working in Greece. The country needs even more liquidity, no firm agreement has been reached on the bond write-downs, and the austerity measures are not really being implemented. If this standard prescription fails in Greece, it raises the question about how successful it is going to be for other countries if and when they need help. This is not a good omen.
It Could Derail Euro
The only reason Germany is even considering bailing out Greece is because the two nations share a common currency. If Greece were on its own, it would have long ago devalued the drachma or defaulted on its debt and been done with it. However, the euro makes things much more complicated. If Greece were to spiral out of control and the rest of the EU choose not to step in, the country could abruptly be forced to leave the euro. The truth is, no one knows exactly what would happen if Greece left. It could put incredible pressure on other debt-laden countries (paging Italy and Spain) and could have all sorts of other knock-on effects. If Greece is unwilling or unable to implement the austerity controls imposed by Germany, then Greek leaders could suddenly find themselves without a lifeline, and that wouldn't be good for anyone.
Exposes Political Risk
The large domestic political challenges in Greece highlight one of the biggest pitfalls in implementing the rescue plans. The Greek government wants to make changes to enhance the country's competitive positioning and to solve the debt crisis, but the rest of the Greek bureaucracy and the Greek people are less sure. You can pass as many laws as you want, but if there is no popular mandate that the changes are necessary then they have little chance of being implemented.
The changes the Greeks (and the rest of Europe) are trying to make are not minor. Huge overhauls of a government's role and the basic functions of how the economy works are not easy. There is going to be a lot of dislocation and pain as the changes are made. If they are seen being imposed from an unelected, technocratic government backed by a foreign power, it is easy to see why stakeholders are dragging their feet in implementing them. If Europe can't convince ordinary Europeans of the importance of saving the euro and of ceding more power to a new international fiscal entity, then no number of press conferences can bring the euro into a lasting union.
Steals Focus
If Greece keeps failing, it's going to begin to steal focus from the more pressing long-term issue of creating a credible fiscal union. What the European community needs to be focused on these days is creating a credible framework that will convince investors that they don't need to worry about another huge runup in national budget deficits that will necessitate another huge round of bailouts. If more emergency meetings are needed to get Greece onto a sustainable path and address near-term liquidity restraints, that is one more day Europe is putting off the harder, long-term discussions. Those discussions can only be put off so long before the market loses its patience even more and the crisis accelerates further.
So even as the headlines might continue to be focused on the larger economies in Europe, keep a close eye on Greece. It's saga and role in the crisis is far from over.
What do you think? Will Greece be ablet o implement successful austerity measures? Can it make its economy competitive without a currency devaluation?
Bearemy Glaser is the bearish alter-ego of Morningstar markets editor Jeremy Glaser.
