Greece is riskier than the markets seem to think

Financial markets should be more worried about Greece. There is perhaps a 50 percent chance that the Greek government will fail to repay the IMF or the European Central Bank (ECB) in the next month or so. This would be intended as a temporary expedient and it might galvanize a deal with Greece’s creditors that would buy everyone a few months to work out the next stage. However, a default would create many economic and political risks, leading to a significant probability of a Greek exit from the Euro.

Such an exit would do serious harm to Greece, as I have written previously, and would damage the rest of Europe to a more modest extent. Markets seem complacent about the probability and risk of a Greek exit. The actuality should lead to significant increases in the required yields for borrowers in Portugal, Spain, Italy, and anywhere else that there is a possibility of an eventual exit from the Euro, however unlikely it seems in the near-term. Once the barrier to exit has been breached, the possibility of more departures in the years to come must be taken seriously and that should be reflected in the required interest rates. These rate increases would reverse many of the benefits of the ECB’s quantitative easing program, which has helped restart the European economy.

This is not to suggest a panicked over-reaction by markets, though. My base case remains that Greece will work out a deal with its creditors, either prior to, or shortly after, a temporary default. Further, the Eurozone is in a much better position to handle the effects of a Greek withdrawal than it was. A Greek exit would not turn out to be a “Lehman moment” when the world falls apart, although there would certainly be some negative surprises as we discover economic and financial links that we had not focused on. Both sides would be well advised to avoid a Greek exit, and they probably will, but Greece would be damaged much worse than Europe as a whole if the negotiations go wrong. As for the U.S., we would be adversely affected as well if things go very wrong, but the consequences for us would be much less.

My view is more pessimistic than it was earlier. Two weeks of meetings in Europe have convinced me that the potential for a very negative outcome on Greece is higher than I thought and that it is very difficult to analyze the risks, which argues against complacency. Adding to this, the favorable turn that had seemed evident in negotiations has been replaced by a noticeable hardening of positions. The major analytical difficulties, and the big real-world risks, center on Greek politics. Here the answers are simply unknowable. The vast majority of analysts, myself included, do not have a deep understanding of Greek politics. Worse, even the savviest follower of Greece cannot reliably guess what will happen in a situation that is completely novel.

The big question is whether Greece will be able to secure a short-term deal with its European funders that will buy everyone a few months to begin negotiating for the longer-term. By late July, Greece will be unable to make payments to the ECB and other official creditors, if it does not run out of funds before then. (This could happen as early as the next couple of weeks, as payments to the IMF come due.) If there is a breakdown in negotiations and a default, even a temporary one, there will be deposit runs on Greek banks that will almost certainly force the government to impose capital controls and limits on bank withdrawals. The confidence shock to the economy, combined with the practical harm from such controls, would quickly send the nation into a serious recession, unless a deal is struck quickly to reverse the default and secure European funding.

We have known for months the essential outlines of any deal that would be acceptable to the Europeans and might pass muster with Greece. Budget targets will have to be loosened from what the Europeans were previously demanding, but would be tougher than the Greeks might like; the new Greek government will have to agree to push through some of the unpopular “structural reforms” and revenue raising measures agreed by the previous government, but Greece will be allowed to slow down or halt some other reforms; and debt maturities will be extended out even further and already-low interest rates dropped more. However, Europe is unlikely to accept Greece’s demand for a formal write-off of a portion of the debt burden. The exact terms will matter, but not nearly as much as the general principles.

The problem is that we simply do not know whether the new Syriza-led government of Prime Minister Tsipras will agree to such terms and whether it can hold its parliamentary majority if it does. Syriza’s name stands for the “Coalition of the Radical Left.” They do not look at politics or economics in nearly the same way that the other ruling parties in Europe do; many members are committed communists who do not really buy into capitalism, much less the austerity policies and structural reforms that their European counterparts believe are required. Further, many Syriza members of parliament were basically café revolutionaries, with no expectation until very recently of holding power. Thus, Syriza has never gone through the necessary internal fights to work out how to balance pragmatism and ideology. To their credit, many members of parliament appear ready to give up their new roles in government in order to abide by their long-standing principles. However admirable this might be on the personal level, it makes it much harder to cobble together a deal that will necessarily stray considerably from Syriza’s ideology and electoral promises. It appears that somewhere around a third of Syriza’s members of parliament would rather have Greece exit from the Euro than go back on any significant electoral promise.

Further, most of the votes for Syriza came from people who do not share the party’s ideology, but simply wanted a government that was not part of the disasters of the past, not tied to special interests, and that would stand up for Greece against its creditors and negotiate the best possible deal to stay in Europe. This means that Tsipras must find a way to hold together his very left wing parliamentary members while appealing to a wider mass of voters who are much less radical.

Tsipras seems genuinely to want to strike a deal with Europe and to remain Prime Minister. He will continue to work hard to bring his left-wingers around. However, no one, including him, can be certain that he will be able to manage this. He can afford to lose the support of a modest minority of his members of parliament, and almost certainly would. There are other political parties who could be brought into the coalition, such as To Potami, which shares some of the goals of Syriza but clearly wishes to remain in the Eurozone. But, this can only work if Tsipras can hold down his defections to no more than about 20% of his members. (He could technically lose more and offset this by bringing in one or both of the traditional establishment parties in a government of national unity, but it is hard to see how this would be done without shattering Syriza, which is vehemently anti-establishment.) We simply do not know if it is feasible to hold defections to this level. My base case continues to be that a breakdown of the negotiations, and the real world harm that would bring, will be necessary, and sufficient, to instill the needed realism within his party. But we do not know if even that dangerous path would lead to a final deal.

In short, there is still likely to be an eventual deal to avoid the worst outcomes, but the probabilities of disaster are too high to justify the nonchalance the European financial markets are showing. The very fact that we are arguing about Greek political outcomes demonstrates the riskiness of the situation.