Should we go back on Greek PSI?

A senior member of the ECB governing council, Athanasios Orphanides, recently argued in the Financial Times that the eurozone should jettison the deal reached on Greece and abandon the Greek private sector involvement (PSI). Such a complete policy reversal would restore confidence in the sovereign bond market, so his argument went. Orphanides claims explicitly that the deal reached on 21 July 21 2011, which involved the private sector in the burden sharing, increased the borrowing costs of other eurozone countries and triggered contagion. So should the eurozone follow Orphanides advice?

For once, it is not true that the deal of 21 July led to an increase in borrowing costs across the eurozone. A simple look at the facts shows, in fact, the opposite. Government bond yields decreased in the week after the summit across the eurozone. In Portugal, bond yields dropped by one percent, in Ireland by almost two percent. Spain also benefited from lower borrowing costs and so did Austria, Belgium, France, the Netherlands, and Finland. Even Greece benefited from the deal with lower government bond yields. Only Italy did not see its bond yields fall. Taking a longer term view by calculating the change in ten year government bond yields from June to September of 2011 gives a similar picture. Austria, Belgium, Germany, France, Ireland, the Netherlands, Finland, Spain, and Malta saw falling bond yields. Prima facie evidence thus does not support Mr. Orphanides claim.

Admittedly, the picture for the summit conclusions of 26 October looks different. Following this summit, borrowing costs increased across the eurozone except for Germany and Finland where bond yields remained unchanged. Is this the result of Greek PSI? This is not evident at all. The summit also included a questionable announcement about bank recapitalisation in relation to the exposure of banks to sovereigns other than Greece. Implicitly, the summit thus gave the message that one intended to prepare banks for a haircut on the entire eurozone periphery. Also the fact that the CDS insurance for government debt was not triggered may have added to borrowing costs as it undermined trust in the system. Last but not least, the Greek government put into question the whole deal reached only three days after the decision by calling for a referendum. It appears more than doubtful that the markets reacted to Greek PSI.

Putting into question the Greek PSI also means that more financing by others is needed. Greek PSI is a reaction to the clearly visible insolvency of Greece. Insolvency can only be addressed by a significant reduction of the debt level. Excluding the private sector from that implies de facto significantly larger fiscal transfers from the rest of the eurozone. Politically, it is difficult to see how one can sell fiscal transfers without involving banks in the burden sharing.

There is, however, a more fundamental reason why a policy u-turn would have very negative effects on the eurozone. 2011 will be remembered as a year of many decisions and less implementation. Even more worrying, it will be remembered as a year of constant questioning of decisions taken collectively. The eurozone now needs to demonstrate that it is able to act. Important decisions have been taken. First of all, a firewall has been put in place. It is sufficiently large and ready ready to help with bank recapitalization in Spain at favorable rates if such a need arises. It is also large enough to cover immediate financing needs for Spain and Italy if market access broke down.

Fortunately, this is not the case at the moment. If market access was breaking down permanently, the eurozone would see significant difficulties as Italian debt is very large compared to the tax resources of the euro area as a whole. Second, important decisions to anchor fiscal policy expectations by a fiscal compact are almost finalized. A clear fiscal framework will help calm investors as it increases reliability. This is evident by the fall of sovereign bond yields in Spain following the decision to introduce a constitutional debt break. Third, the eurozone has the tools to implement much needed structural reforms and should use them.

Going forward, the eurozone needs to develop a clear strategy to promote growth and also more determined action to solve the problems in the banking system. Finally, we need to work on a vision for a true fiscal federal structure with a transfer of sovereignty to Brussels and a eurozone budget. Constant questioning of collectively taken decisions certainly does not help to solve this crisis.

* Guntram B. Wolff is deputy director of Bruegel, a Brussels-based think tank contributing to the quality of European economic policy making.