Treat liquidity risk and runs on institutions as fundamentally a question of lack of information – the lack of information on the underlying financial solvency prompting flight from uncertainty. In that case, the question following the announcement in the press yesterday of the Greek-EU bailout is not so much what it signals about liquidity, as instead what contribution it will make toward the forward discovery of Greek solvency – if any.
As many observed, this announced deal consists of a fixed amount of money committed, rather than vague political promises. At some 30 billion euros, plus additional commitments from the IMF, yes, of course, the effect of the announcement eases immediate liquidity fears. (Although perhaps the issue of the signoff of seemingly everyone in the EU with a pen in order to release the funds raises some hold-up questions in theory, but probably not in reality.) What remains is whether this breathing space will do much to fill in the missing information about Greece’s underlying solvency. As the WSJ’s Richard Barley says in today’s Heard on the Street:
Even the clearest, most credible part of the deal—the interest-rate mechanism—raises questions. On one level, a 5% rate for a three-year fixed-rate loan represents a concession relative to last week’s market levels. But this is still 3.7 percentage points over three-year German debt—a long way north of where the Greeks would like to be able to borrow. Indeed, if Greece were to take a 10-year loan under the package, it would be at a rate of well over 7%—the rate the market would have charged last week.
In a curious way, this may act as a floor to private-market rates. Why should a bond investor lend money more cheaply than other euro-zone governments are willing to do? After all, two-year yields on Greek debt, while down sharply from last week, are still 5.47%.
The level of interest rate demanded as the bailout puts the EU in the position of setting it low enough to bring down private rates, but high enough to meet Bagehot’s condition for avoiding moral hazard in bank runs (lend freely, but at punitive rates, etc.) But the uncertainties over solvency in the longer term remain broadly political. Barley goes on to discuss the political issues of contributions by EU governments – including Spain, Ireland, and others also under pressure. Questions of the behavior of outside guarantors, including EU states, is one set of uncertainties.
But perhaps the greatest solvency uncertainty, and one which is not necessarily helped toward price discovery by means of the liquidity breathing space offered by the current funds, is whether Greece will be able to do anything near to what it has promised in the way of internal fiscal reform. One can always frame that question merely as whether investors will roll over existing Greek debt and at what price. But that question depends on their assessment of uncertainties related to the fundamentals of the Greek economy, its competitiveness, and its fiscal policies. Is the Greek economy capable of servicing its debt load?
It is not a matter of an injection of liquidity, in other words, for the purpose of allowing for outsiders time to find out the “true condition” of the balance sheet of an institution. It is far more for the purpose of allowing outsiders to assess the ability of the government to reform that already whacked-out balance sheet. The immediate bailout funds will not last long enough to see a convincing answer to that question over the future which it necessarily entails. So outsiders will be making an assessment of political risk into the future. Will they believe the Greek government and Greek society that, for example, its current austerity measures and fiscal reforms will stick? Should anyone believe that? Beyond austerity measures, is Greece capable of taking measures that would improve its productivity, competitive position, on economic fundamentals? I don’t merely mean the devaluation that would inevitably result if there were still a drachma, but improvements to its competitive position through changes in its economic fundamentals. Those are the uncertainties that matter, internal to Greece – uncertainties that are about the fundamental solvency of Greek society, and not just its sovereign debt position.
Outside investors have two bets to make as this new liquidity facility winds through the system. One is on the EU and how long and how much it is willing to extend liquidity. The other on Greece, the Greek government but also Greek society, and it is fundamentally about, not liquidity, but solvency. The wonder, frankly, is that news stories over the weekend were suddenly talking about Greek solvency, as though it had ever been anything other than the fundamental question.