Financial markets heaved a sigh of relief last week when agreement was reached on the next stage of the Greek bail-out. But the key problem remains: Greece has an unsustainable debt burden. This problem has been kicked down the road yet again.

The Greek rescue started badly. Even in May 2010, it was obvious Greece was insolvent and the proper response was a debt rescheduling or de facto default. Instead, the problem was papered over with an assistance program orchestrated by the 'troika': the EU, the European Central Bank (ECB) and the IMF. The IMF's participation was not just to provide extra funding, but also to act as the disciplinarian task-master. Sometimes the IMF can also serve as a heat-shield, taking the blame for hard choices politicians are unwilling to make. Because of its technical expertise and experience in crisis management, it carries the main responsibility for forecasts and policy advice.

So why didn't the Fund make the hard choice in this instance by demanding the unsustainable debt be rescheduled? This would have given Greece a realistic chance to get growth going again. It would also have put the losses where they belonged, with the creditors who had foolishly thought that Greek public debt denominated in euros was nearly the same as German official debt. This in turn would have established the right discipline: creditors must beware of lending too much to countries with poor fiscal self-control.

At that stage the IMF's Managing Director, Dominique Strauss-Kahn, had presidential aspirations back home in France. He wasn't likely to assert a position which offended his European colleagues. They, in turn, were not ready for a de facto default.

Financial markets were threatening to spread debt contagion to Spain and Italy. Germany and France were not ready to accept the big losses this would have inflicted on their banks, which held much of the Greek debt. The ECB, for its part, was not ready to accept any weakening of its balance sheet or offer strong backing to counter the threat of contagion.

By early last month, after two-and-a-half years of kicking the can down the road, Greece's debt/GDP ratio had risen from 120% and was projected to be 190% by 2014, largely because Greek GDP is 20% lower than initially forecast.

The measures agreed last week are designed to show that the situation is still sustainable. Interest rates on the assistance have been lowered to concessional levels, the maturity has been lengthened by 15 years, the ECB will return 'profits' on Greek debt to Greece, and Greece will buy back around half of the residual debt still held by the private sector at a price well below face value.

Even with the benefit of these measures and unrealistically optimistic assumptions about budget performance and growth, Greece's debt to GDP ratio is projected to be 126% in 2020, thus missing the IMF's sustainability line-in-the-sand.

All this puts the IMF in an unenviable position. In normal circumstances, if it assesses that a country has an unsustainable debt level, a debt rescheduling would be required before support is offered. Not only is this sensible economics, but unless this is done, the Fund's money is at risk. What if the Fund had done this in the beginning? We don't know how this would have played out, but one seasoned observer says:

Just imagine what would have happened had the no bailout rule been invoked in May 2010. Greece would have gone to the IMF and defaulted on its smallish public debt of 120% of GDP. By now, the crisis would be over.

The Fund is clearly uncomfortable with last week's outcome, and its agreement is conditional on a successful buy-back of debt. In the course of the negotiation, the IMF Managing Director is reported as saying: 'it's not over until the fat lady sings'.

But the Fund has little choice other than to go along with this deal. Europe clearly wants all this put on hold until after the German elections in September. In the meantime, the interest burden on Greece is bearable, but Greece cannot meet the forecast growth targets because the weight of foreign debt discourages investment and entrepreneurship and causes a state of chronic uncertainty. Even under the best circumstances, another round of debt reduction will be needed before the end of 2013.

The fat lady has not yet sung: the debt buy-back is still to be arranged. Those still holding Greek debt (such as the Greek banks) may not have this valued in their books at market price and will realise substantial losses if they sell. In any case, opera buffs will be worried about the fat lady reference: when Wagner's Brunnhilde stopped singing, the world ended.

In a governance sense, the troika's assistance program sets unfortunate precedents. Unsustainable debt has been rolled forward. Private sector creditors have come off better than they should have, with maturing debt repaid out of official assistance. The IMF's credibility as a forecaster has suffered and its reputation as a stern task-master has weakened. Working as part of the troika has tied the Fund's hands: will it be as ready to work in tandem with other regional arrangements such as the Chiang Mai Initiative?

The treatment of Greece has also reinforced the view that the Fund is Euro-dominated and more helpful to advanced countries. There may even be pressure on the Fund to participate in the inevitable debt-reductions later, even though its money is regarded as 'super-senior'. And the enduring European crisis has been bad for world confidence and growth.

IMF head Christine Lagarde has done what she can to play the unfortunate hand which Strauss-Kahn thrust on her as he left the Fund. She understands that the Fund's rules, based on economic logic, have to be trimmed to take account of political realities. The European mess is, in its essence, a political problem and she has been negotiating with Prime Minister of Luxembourg Jean-Claude Juncker, the man who invented the politicians' favourite aphorism: 'We all know what to do, we just don't know how to get re-elected after we have done it.'

Photo by Flickr user World Economic Forum.