This weekly is a follow-up post to the daily I wrote on Greece earlier in the week. As I indicated then, my position on Greece has always been that eurozone leaders would be loathe to ‘kicking Greece out of the euro zone”. The talk of a Grexit is not well-consdered without putting this important point at the top of the list of political and economic constraints. Instead of Grexit, what we should be discussing in the context of Greece is how well or poorly the Greek economy is functioning and what that will mean in terms of Greece making targets, public protest, and the likelihood of follow-on bailouts. I would like to discuss those issues here and conclude with some predictions about where I see the Greek situation heading in the next five to seven years.
Hindsight is twenty-twenty. But, in reality, few people understood the gravity of the sovereign debt crisis when it began with Dubai World’s default in November 2009, three years ago. When the Greek crisis began soon thereafter, few assumed we would end up in such a difficult situation, worrying about depression and political extremism in Greece and the breakup of the eurozone. Therefore, when I write a comprehensive post like this one, I like to see how my thoughts today line up with what I have said in the past. I think it’s important to check prior thinking to develop consistency and to tease out issues you might be missing.
If you are looking to do the same, I would start with a post from last November in which I gave a timeline of the Greek situation. See “The date when it was first obvious that Greece would default: a timeline of the Greek debt crisis“. what follows here are the big takeaways from that post and subsequent events as a background to the bailout deal that Greece recently agreed to with the EU and the IMF.
What’s clear from my own post chronology is that the Greek situation was inevitable given the fragility of the European banking sector and the negative economic consequences of the financial crisis. My January 2009 post on The Eurozone and the spectre of banking collapse makes that clear. However, what was not clear is how much the situation in Greece would deteriorate. I give Hugh Hendry credit for understanding that Greece was deeply insolvent as early as February 2010 and I see everything that has happened subsequently as makeshift responses to this insolvency, constrained almost entirely by political reasons and not economic ones. I think this is an important point because it highlights how deeply economics and politics are interwoven in crisis. While financial and economic crisis make plain unsustainable economic trajectories, political inertia and the commitment to previous economic policies will always mean that the full extent of crisis is not dealt with until the situation is almost near collapse. This is what we saw with Fannie and Freddie, with Lehman and the US banking system, with Greece, Portugal and Ireland, with the US debt ceiling, with the fiscal cliff and with every single economic issue we have struggled with over the past five years. When a crisis starts, political inertia means that the crisis will always get much worse before it is resolved. In some instances, the crisis doesn’t get resolved – and that then leads to economic collapse, hyperinflation, famine and war. But usually political leaders don’t let it get that far. We should always expect the full extent of crisis to be underestimated but to eventually be resolved. My mantra is that we should hope for the best, prepare for the worst and expect something in between.
And so it is with Greece.
The best case scenario when the crisis began was one in which the ECB backstopped Greek debt and Greece took the reforms people wanted it to take as quickly as possible, leading to a robust recovery and an end to crisis in three years or less. Clearly, this was never going to happen because the institutional structure of Europe prohibited ECB intervention – and it wasn’t clear to everyone at the beginning of the crisis that the ECB would have to intervene. Moreover, the crisis in Europe is seen even today by most mainstream EUropean policy makers as one of irresponsible deficit spending. And that means that growth and reform can never go hand in hand because austerity would always be the policy choice used to deal with excessive deficits.
Now, when the crisis began, I thought that no bailouts would be forthcoming and that Greece would default and its debt restructured. Clearly, I was way too optimistic. The default scenario would mean reform and restructuring and would imply a quicker return to growth. But that scenario would also mean accepting that Greece’s debt burdens were unsustainable without ECB intervention and then saddling core eurozone banks with losses. European policy makers were neither willing to accept that Greece’s debt burdens were unsustainable nor were they willing to accept bank creditor losses without heaps of austerity first. And this is a process that is still ongoing three years later. My conclusion, therefore, is that I failed to understand how much politics drives the process during crisis. I have since incorporated this understanding into my analysis.
The flip-side of being too optimistic is being too pessimistic. And here I am talking about a Grexit and eurozone breakup. I would say my view is probably somewhat more dour here in that I believe Greece will eventually exit the eurozone. My baseline is for a disorderly breakup. However, I do believe that eurozone policy makers are committed to the euro. And given the lack of euro zone exit mechanisms, I do not believe that a Greek exit is possible in the near to medium-term.
Now, the worst case scenario would be a disorderly default and exit by Greece, followed by copycat defaults and exits elsewhere in the periphery that would lead to the euro’s collapse. Bt this kind of Armageddon scenario would mean the end of one of the world’s leading exchange and reserve currencies. It would mean a complete about face by a number of leading European policy makers. And it would also mean opening up the European and world economies to an enormous wave of economic and political unpredictability. I see this as very far-fetched. It won’t happen.
The most likely scenario for Greece is that we continue on the present path of varying levels of austerity and reform in exchange for bailouts. Along the way, the economic and political situation in Greece will become extreme, making an eventual Greek exit from the euro zone possible – and in my view probable. This exit would occur only after the general crisis had ended and Greeks understood that Greece still wasn’t prospering economically within the euro zone. I wrote three posts on the likelihood of a unilateral Greek exit last February: Running through unilateral Greek exit scenarios, How and why Greece will leave the euro zone, The political economy of a Greek default (and euro zone exit). Read these for a fuller perspective on Grexit scenarios.
The latest Greek bailout
Moving forward to the present, here’s what we got in the big Greece bailout:
Greece’s creditors have agreed to three main points:
- Deferring interest for 10 years, cutting interest rates, and extending maturities by 15 years out to 30 years
- returning 11 billion euros the European Central Bank has accrued through its purchase of Greek government bonds
- allowing Greece to conduct a debt-buyback scheme.
As a result of this, Greece will receive its existing aid tranches in the agreed upon stages, starting with 34.2 billion next month. Much of the bailout money will be used to recapitalise Greece’s banks. The country should remain solvent through 2014 under this deal. The target for Greek government debt to GDP is now 124% by 2020.
In framing the Greek elections and post-election negotiations in June, I wrote that “It is clear that Greece will be unable to hit their deficit targets. According to Die Zeit, Greece is already lagging on tax revenues and privatization proceeds. This is why the German government is already debating relaxing Greece’s austerity targets. So the fact is that the bailout package will have to be renegotiated regardless of what happens in Greek elections. This is a key point missed in the public discussion about the Greek situation. The question regarding the Greek election mostly concerns negotiating position… PASOK and New Democracy have signalled to the Germans that… a Greek exit would be catastrophic. Their negotiating position is weak. Syriza has said that they will not accept the German negotiating position and that they will fight for the spoils of the negotiated outcome on behalf of the Greek people against foreign and domestic bank creditors. But they too have said that a Greek exit would be catastrophic. ” In sum, it was clear that an imminent Grexit was always a non-starter. After the elections saw a rejection of leftist Syriza, it was also clear that the likelihood of a new Greek bailout was high.
The political considerations for a bailout were principally about how much austerity and reform to press for and whether to allow for a default. As I indicated in the daily, in Germany, Angela Merkel wants to be able to say she has not let Greece off the hook easily and that Germany has not committed any funds to a Greek bailout, just guarantees and liquidity. The goal is to be able to keep the euro zone intact and to mollify her centre-right coalition and voters who are concerned about Germany’s own economic health and suffering from bailout fatigue as a result. For the past three months I have argued that Germany would refuse to commit any more money to euro zone bailouts for fear of Germany’s own credit rating. I dubbed this stance “The end of European bailouts and the beginning of monetisation“. The latest Greek bailout s very much in line with the German coalition’s pre-election policy stance of “no new bailouts” in that no new funds are being committed to Greece. This is crucial for the 2013 general elections in Germany. Merkel wants to be able to say that her government has not committed any taxpayer money beyond liquidity and guarantees and in any event has stopped adding to new guarantee and liquidity commitments it has already made. The ECB’s monetisation policy and the new Greek bailout deal allow her to do this. SImilar considerations are important elsewhere in the core, especially in Finland and the Netherlands, where bailout fatigue is running high.
The IMF has been pushing for default because they believe the situation in Greece is unsustainable because the debt load is too high. I agree with this view. However, I do want to point out a well-reasoned counterargument from Daniel Gros. As Gros points out, the ECB won’t go along with more haircuts as this would force the ECB into an undercapitalised state, requiring a top-up from euro zone members including Germany. Effectively, a haircut which would inevitably include official sector involvement (OSI) would necessitate Germany and others using real funds, not just guarantees and liquidity. Clearly then, that is unacceptable politically. But Gros argues that, irrespective of official sector self-interest, the debt burden in Greece is sustainable if interest rates are low enough and growth rates are high enough. Fair enough. But that scenario involves two outcomes I don’t see as politically sustainable. To keep interest rates low in Greece requires ECB intervention when the ECB has explicitky said it wants to play no part in setting rate caps in Greece. Moreover, the official line in core euro zone countries is that the existing bailout loans are only provided as liquidity to be repaid in exchange for structural reforms and austerity in Greece. And this austerity means growth cannot be robust. So, the IMF is right; Greece’s debt burden is unsustainable and it will take more austerity and failed targets for this to become clear.
As things stand now, Greece’s 2013 budget forecasts a sixth year of recession. Greece will aim for a primary surplus (not including interest costs) that will hit as high as 4.5% in 2014. This way, they can make the deficit hurdles and reduce their debt burdens at the same time. The goal is to make the debt and deficit hurdles, and that means reducing government expenditure and raising taxes, both of which guarantee continued recession and delay the possibility of growth. The hope is that growth will eventually kick in and whittle away the debt problems. If not, haircuts will be back on the table, but conveniently only after the German elections are over next year.
I have already gone into a bit of what a Greek default means for the ECB and what a Grexit means in terms of its potential domino effect. But let me spell out more explicitly what the further considerations are for five parties: the ECB, Portugal, Ireland, Italy and Spain.
The ECB understands that it can provide liquidity to countries via its asset purchase programme only in order to reduce redenomination risk. This means its role has to be limited to buying the debt of solvent governments where yields have risen, ostensibly because of the prospect of eurozone breakup. While Greece’s leaving the eurozone remains a risk, the country has already defaulted on its bonds in the past and is therefore not a candidate for the ECB’s intervention. This is what Mario Draghi has told leaders in Brussels with regard to the ECB’s likely policy response. ANd we have to remember that the ECB is already sitting on a lot of Greek bonds it bought previously which could be written down. On the other hand, the ECB believes it is legally permissible for it to sell the bonds it has already acquired to the European Stability Mechanism at the price at which the ECB purchased them in an effort to help Greece buy back its debt. The benefit of this approach is obviousl that it relieves the ECB of the Greek bond burden and that it could help reduce Greece’s debt burden.
Like Greece, Portugal is unlikely to make targets and is therefore likely to get another bailout when the existing one ends. As I wrote in October, Portugal is prepping itself for the ECB’s outright monetary transactions (OMT) programme by making a draconian austerity budget that raises taxes and slashes spending with a 4.5% deficit goal for 2013. If Portugal is semi-successful in this effort, given its lower debt burden, the ECB would likely make the country eligible for the OMT programme which it has denied to Greece. I believe that European policy makers will push for Portugal to formally apply for the OMT before its existing deal lapses so that it can move into an OMT-style bailout instead of the one it has right now. This would mean that the existing EFSF funds would be repaid as Portugal raises money on the open market, with the ECB buying up secondary issuances in enough size to bring yields down to sustainable levels.
Unlike Portgual and Greece, Ireland has been making targets and is therefore likely to be able to sell debt on the open market when its existing bailout ends. The question goes to how much ECB help it will need and whether it has to apply for an OMT-style package like Portugal. Because the original Troika bailouts saw Greece first, followed by Portugal and then Ireland as the last country. We will get a chance to see what happens in Greece and Portugal first before Ireland has to make a decision about the OMT programme.
We could also well see Spain apply to the OMT before Portugal or Ireland do because they are the country for which the programme is most intended. As Spain is still solvent and has not received a bailout yet, it is the country that is in greatest need of the kind of liquidity the OMT programme can deliver and there is great pressure on the country to formally apply. I believe Spain will eventually need to apply as its banking sector and regional debt burdens are too high.
Italy is the last real peripheral country and they are closely tied to Spain. The question is whether Italy will succumb to the OMT if Spain makes a formal application. Italy’s ability to move out of the periphery are predicated on two issues. First, Italy needs to show it is making progress on structural reform and budget issues. The country is already in good shape regarding its primary budget statistics. The question is about growth – and to the degree it can regain competitiveness, Italy could regain growth. The same goes for France by the way.
Greece is in a severe economic depression that was precipitated by the back to back nature of the global financial crisis and the European sovereign debt crisis. The prevailing economic model in Europe says that government debt and deficits are the problem and that these debts and deficits must be cut by raising taxes and cutting spending. This world view has induced an even greater contraction in economies of the European periphery and induced a debt deflation, with Greece suffering the worst. In all likelihood, political inertia and economic ideology are such that these policies will continue irrespective of the political and economic consequences in Greece.
The Greek government has already agreed in principle with its creditors on a continued austerity path that will see Greece continue recession through at least 2013. The question is how much economic damage this path will create and whether the damage radicalizes Greek politics further. In my view, the Greek situation is not politically sustainable within the eurozone over the long-term because I do not believe that Greece can pare down its debt and regain competitiveness on a sustained basis without a currency devaluation. As a result, I expect Greek politics to radicalize and for Greece to seek a mutual agreed but somewhat disorderly exit sometime within the next 5-7 years. Depending on the economy and how quickly the political situation radicalizes, this timetable could be accelerated considerably. For example, just pushing through the latest deal could cause the current government to be overthrown. Nonetheless, I do not expect a Grexit in 2013, though default is a possibility if Syriza gains control of the government.
For now then, the Greek deal seems to fit the bill. It does not create an unnecessary domino effect that catapults Spain, Italy or France into crisis. And it does not force a public sector default with destabilizing political consequences. However, I expect Greek politics to radicalize as the economic situation worsens. And I expect a Greek re-default down the line, but this will probably not occur until after 2013. In the meantime, attention will shift away from Greece to the rest of the periphery and to France, where the situation is also becoming more precarious.