Cost of a third Greek bail-out is likely to be too high for Europe

In mid-July, following marathon negotiations which included serious discussion of whether Greece should now leave the eurozone, it was agreed that negotiations should be opened about giving Greece a third bail-out. That bail-out was expected to be about €85bn (£59.6bn). That figure was based upon two important assumptions that have since been, rather dramatically, overturned.

First, it was assumed that (at least from March 2016), the Internatonal Monetary Fund (IMF) would participate. The exact amount of any further IMF loans to Greece would have to be agreed in due course, but if previous bail-outs were any guide, one might have expected the IMF involvement to be of order of 10pc to 20pc of the total. So the IMF would provide some €8bn to €15bn, with the eurozone states providing the other €70bn or more.

Subsequently, the IMF has said it will not participate unless Greek debts are written down and unless Greece can prove itself more committed than in previous bail-out programmes to actually carrying through with reforms. That effectively means the IMF will not take part at all. There is little to no chance of the main eurozone creditors such as Germany agreeing to further write-downs of Greek debt – especially not in a context in which they are supposed to agree to provide it with a lot more.

There is also relatively little chance of Greece being able to demonstrate the necessary additional commitment to carry on with reforms, given that its government is badly split, there are likely to be new elections and the governing Syriza movement (which says it does not believe in the economic reform programme that is an integral part of the third bail-out) is likely to win those elections with an even larger majority – though perhaps thereafter facing a larger anti-euro opposition than before.

Since the IMF is now de facto out, that means the eurozone states will have to find an extra €8bn to €15bn on top of what they would have been anticipating at the time of the mid-July agreement.

But that is not the end of the extra funds now needed. The estimated scale of the third bail-out was based upon assumptions of how the Greek economy would perform over the next few years – in particular how much tax it would raise and hence how much it would need to borrow to cover the government budget. There were also important assumptions about how much money the Greek banks would need to be recapitalised.

Those economic assumptions will now need to be revised significantly. On Monday, the latest estimates were released for the performance of the Greek economy in July. They ranked somewhere between the “unprecedented” and the “unbelievable”. Greek manufacturing output collapsed last month at a rate never previously seen in a developed economy. Greek economic output as a whole may contract by more than 5pc in 2015 – and that’s assuming things for the rest of the year are fairly stable and nothing else goes wrong.

One thing that means is that the budgetary assumptions underpinning the assumption of an €86bn bailout will need to be substantially revised – the total needed to cover the Greek budget will undoubtedly rise. But that is not the end of the revisions. For with the economy doing even worse, the Greek banks will struggle to get their debts repaid – with further economic contraction, mass defaulting will leave the banks insolvent.

The Athens stock exchange re-opened on Monday. Greek bank stocks tanked, dropping by, or close to, the maximum permitted amount of 30pc on each of the first two days. Recapitalising the Greek banks is now going to be significantly more expensive than previously anticipated.

It is not out of the question now that the final figure for a third Greek bail-out might exceed €100bn and that that will all be borne by the eurozone states, with no participation by the IMF. The net effect could be that eurozone states would have to provide half as much again as they thought they were agreeing to in mid-July.

^{Greek PM Alexis Tsipras}

Given how difficult the mid-July agreement was to achieve, it must be likely that discovering the bill is half as big again as expected and that the IMF will not be involved will be the last straw for certain eurozone members. Perhaps, though, enough eurozone members will still want to see the deal through, even at higher cost, that Greece will stay in the euro once again. The French say that no country must ever be allowed to leave the euro. European policymakers in general have a morbid fear that any eurozone departure would take the currency down the route that the EU’s previous monetary arrangement, the notorious Exchange Rate Mechanism of Black Wednesday fame, took in the early 1990s, whereby one departure led to another and eventually the whole arrangement fell.

I, by contrast, believe Greek departure would strengthen the eurozone. French policymakers have become ever more explicit in their calls for the eurozone to establish itself into a fully fledged political union, with tax-raising and spending powers, a parliament and the whole shebang. That must be the right way to go – both for reasons of the political destiny of Europe and also for the economic integrity of the eurozone.

Some commentators object that such a political union would require a new treaty, and new EU treaties have not been feasible since Lisbon. But it need not be a treaty of the whole EU. Subsets of countries within the EU have established a number of treaties in recent years – most notably the Fiscal Stability Treaty agreed to in early 2012 (following David Cameron’s notorious “veto” of December 2011). A eurozone political union treaty could follow this “coalition of the willing” route, starting with perhaps a half a dozen eurozone members (for example France, Germany, Italy and the Benelux countries), extending an invitation to other countries to join later.

A key obstacle to such fully-fledged political union is Greece. Will Finland, Germany and others agree to a common eurozone budget if it seen as a covert way to send yet more money to Greece? I think not. Fortunately, my guess remains that the third Greek bail-out will never happen. The detailed terms will probably be rejected by both Greece and key eurozone members. Then we shall discover if Grexit really holds the terrors many claim.

Andrew Lilico is executive director and principal of Europe Economics