The Euro Summit: Turning Point or Mirage?

by Douglas J. Elliott

Brookings Institution
October 27, 2011

It was not pretty, but European leaders succeeded around 4:00 a.m. today in announcing a package of steps addressing the euro crisis. European financial markets responded quite positively, with a 4% rally in European stocks and decreases in market yields on Italian bonds of about 0.15%. The market reactions are important, because this stage of the crisis resolution is about restoring market confidence while longer-term structural changes are worked out.

The announced measures could be the turning point in the euro crisis or just a mirage, because many questions remain both about the details and about how markets will respond once the initial relief rally passes. Each of the key pieces of the package can be viewed positively or negatively:

Greek debt reduction: European leaders reached an agreement in principle with a representative of the banking industry for “voluntary” reductions of 50% in the economic value of Greek sovereign debt. In truth, the agreement is roughly as voluntary as when one hands over one’s wallet in response to the choice of “your money or your life.” This was underlined when President Sarkozy of France apparently threatened that the other choice was a 100% haircut, a complete refusal to repay any Greek sovereign debt. The theoretically voluntary nature is important for legal reasons, but creates the risk that the agreement in principle will fall apart when it comes times for each debtholder to decide whether to participate, especially as the actual exchange offer will be a complicated one.

Beyond the immediate issue of designing a successful exchange offer, there is the larger point that, if everything works out as planned, Greek government debt in 2020 will still be at around 120% of the size of its economy. This is not a level that is clearly sustainable, meaning there is a real chance that Greek debt will be restructured again in coming years, with more losses for bondholders.

So, the good news is that this is a major step toward creating a long-term solution for Greece. The bad news is that it could fall apart in the short-run and there are considerable risks that it is insufficient in the long run.

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