What to Expect in Greece (June 2015)

By Roy C. Smith

On June 30^th, Greece is due to repay €1.5 billion of the €9.7 billion it owes to the IMF this year. An additional €6.7 billion is due to the European Central Bank (ECB) during July and August.

In 2012 Greece forced a restructuring of approx. €200 billion of its “private sector” creditors (i.e., banks), an action that was declared an “event of default” by rating agencies. This crammed-down restructuring, however, excluded “public sector” creditors such as the IMF and the ECB, and did not constitute a default on public sector debts.

Defaulting on payment to public sector creditors is a big deal. No country has ever defaulted on IMF loans in its 70-year history (though several basket-case countries, e.g. Zambia, have gone through a slow-pay-in-arrears process). Public sector creditors are required by their charters to deny additional credit to defaulting governments.

The presumption by European officials is that a default on the IMF loans, would constitute a default on the ECB and European Financial Stability Fund (EFSF) loans that have comprised the €240 billion Eurozone rescue package for Greece that began in 2010.

Background of the Crisis

The EFSF rescue package was put together on the fly by the 18 countries that (then) utilized the euro (the Eurozone) to assist Greece in restructuring its debt and its economy so as to be able to remain in the group. It was based from the start on partial payments being made as required restructuring and reform “conditions” were met. Since 2010, many of the partial payments have been delayed or argued over by Greek governments protesting the severity of the conditions required.

In 2008, Greece’s economy sank 4.5%. After a brief recovery in 2009, it remained in negative territory until 2014 (averaging about -1.5% over five-years), when it became positive for about 6 months, indicating a turnaround. But the turnaround did not hold and the economy sank again into modestly negative growth rates. The prolonged recession in Greece (which was considerably less severe than the recessions in Ireland, Spain and Portugal and other small Eurozone countries) imposed economic hardship on the country that resulted in the election in January of 2015 of an extreme left-wing party, Syriza, whose leaders have insisted that the terms of the EFSF loans be relaxed to ease the hardship that Greeks were experiencing.

In 2010, the European Union authorized a negotiating group (the “Troika,” consisting of the European Commission, i.e., the administrative arm of the EU, the ECB and the IMF) to deal with the Greek government on these issues.  The Troika negotiated the rescue package and the conditionality under which it was to operate. These required lowering the Greek fiscal deficit (largely by reducing large government payroll and pension costs), debt restructuring (to extend maturities) and macroeconomic reforms (improved tax collection, privatization, etc.).

The austerity imposed by the conditionality has not, however, resulted in sufficient economic recovery to enable higher tax collections and other deficit reduction efforts.

The Troika has expressed some sympathy for this situation, but (reflecting the views of other Eurozone member countries) is not satisfied that Greece’s efforts to manage the restructuring process has been what it should have been, and fears that more loans that do not meet conditionality requirements will be a long-term waste of Eurozone taxpayer’s money.

High Stakes of Default

So the existential question is whether, even with further assistance from the EFSF, Greece will ever get back to being a normal Eurozone country. (Despite the aggressive negotiating practices of the Syriza Party, recent polls show that 70% of Greeks want to remain in the euro. German polls, however, show support for Greece remaining in the euro to have dropped to 40%).

Five years of negotiating with the Greek government has tired out the Troika. Many in Europe believe that the admission of Greece into the Eurozone was a mistake – Greece was never a first-world, developed economy – and if Greece won’t comply with the terms of assistance, then it should leave the euro even at the cost of large write-offs being absorbed by the EFSF and the ECB.

There is consensus among economists, however, that Greece would be better off to accept the conditionality imposed on it rather than face the economic chaos of a default and probable exit from the euro. A default would mean a cut off of future EFSF funds, a denial of all forms of external credit, a run on domestic banks and financial institutions (as depositors try to protect themselves against devaluation), the collapse of the internal credit and payment system as banks run out of money and cannot rollover maturing obligations, a further plunge in securities and real estate values, and a likely substantial increase in inflation as the government resorts to printing money to cover expenses.

Under such circumstances, remaining in the euro would greatly increase the hardships; Greece would have to devalue its currency in order to achieve some kind of international payments equilibrium (e.g., tourism and exports could be increased, and wage rates and prices would adjust to what they have to be). But, the only way Greece can devalue is to leave the euro (a “Grexit,” or Greek exit), the cost of which to the Greek economy is hard to assess but it certainly will be steep in the short to intermediate term.

If it leaves the euro, it will be required to impose capital controls (a violation of EU Single market rules) and its economic refugees may flood the rest of Europe, which could pressure Greece’s ability to remain in the EU, which it needs to preserve agricultural and other export privileges.

Even if Greece does not chose to leave the euro, the rest of the Eurozone countries could force it out by refusing further loans and triggering the defaults that would initiate economic collapse, or by voting Greece out of the group. There are many economists who believe this is the right step to take because Greece has shown neither the will nor the capacity to sort itself out under the rules of the assistance programs. Recognize the mistake for what it was and move on.

Yes, Europe could get rid of Greece and the euro and the EU might actually be better for it (despite some large write-offs of public funds). But would this be the most sensible and mature political solution?

Complications of a “Grexit”

The longer the Greek negotiations go on, the more the so-called European “solidarity” issues will be clarified. From the beginning, the Eurozone countries and the EU felt that their great experiment in continental economy unity would be endangered if a member were forced out because of an economic crisis or emergency. A union requires mutual assistance even if is not written into their contractual agreement. Solidarity means helping the weak to recover so as to preserve the whole.

But how long does the solidarity clock run for emergencies or crises? Greece is a small economy, but still the 13^th largest of the 28 EU member countries. Other EU countries (principally Ireland, Portugal, Spain, and Cyprus) have been forced to suffer economic adjustment after the 2008 financial crisis. These countries have received assistance too, but have begun to recover and made their requirement payments on time without a lot of theatrics. By now there are questions about Greece’s willingness to endure the economic pain of the adjustments that are necessary. Certainly the negotiating tactics of Syriza have isolated Greece from the rest of the Eurozone and EU.

Increasingly it seems that more Europeans are accepting the fact that if Greece leaves the system it does not mean a “domino effect” that could destroy the euro and/or the EU will occur and other countries will end up leaving too.

But, chucked out, Greece would most likely plunge into political chaos—Syriza would fall, the country might not be able to agree on a replacement government that was any better, and the chances of civil conflict or a military takeover would increase. At worst, Greece could become a failed state in a region of the world beset with extremism, something no Western government wants to see happen.

Negotiating Strategy

Yanis Varoutakis, Greece’s Finance Minister is an economics professor with a long interest in game theory.  This is basically a way of analyzing an optimal strategy in a multi-party negotiation in which failure to agree results in a very bad outcome, and the winner is the one that emerges with a better relative outcome than others. Most observers believe that Varoutakis’ abrasive negotiating strategy is an effort to apply game theory, but it is essentially a method of bluffing -- he knows that no agreement would produce a very bad outcome for Greece, and that his tactics increase the probability of no agreement, but it would also create a bad outcome for Europe that it very much wants to avoid.

Varoutakis, however, is likely to believe that there is no benefit in striking an agreement before the last possible minute. And that may be after missing the required payment to the IMF on June 30. There is always a catch-up period in which late payments will be counted and default avoided. And this could go on with each required payment through the summer. The Troika is not likely to pull the plug once and for all if it believes that Greece is still bluffing and will in the end come to terms.

The Troika, however, has the money and still controls things. It is also subject to political pressures to no longer tolerate Greece’s obnoxious behavior. At some point there will be a take-it-or-leave-it moment and Greece will likely accept the terms then offered, claiming some success. But that will not be the end of the drama. Greece is likely to fall behind future payments and resume the negotiations in the future, though, perhaps in time, with a more collegial government.

All in all, it seems that Greece is likely to press the possibility of default to the last possible point, even after June 30, in hope of getting something it can claim to be a negotiating success to its supporters in Athens. But it is a dangerous road past June 30 as market forces may take over and begin the plunge into chaos before Varoutakis’ game theory based tactics have run their course.

Already there has been a massive withdrawal of deposits from Greek banks that now rely on assistance from the ECB to stay afloat. The interest rates on Greek government debt (owned almost entirely by Greek banks) have shot up again to unsustainable levels. Market forces are gutting the Greek economy, making the negotiations seem academic. Greece’s best hope is that Syriza recognize this and accept the latest terms on offer before it is too late.

A European summit showdown is scheduled for Monday June 22. With Greece, there have already been several showdowns. It could be that things will get worse, but if so, that might result in a new government more willing to negotiate realistically. By now, Europe has little more to lose by patiently (however disagreeably) waiting for the Syriza Party to run out of support. Better this than throwing everything into chaos with an unpredictable outcome.

Europe can use game theory too.