Greeks Avoid Triggering Immediate Disaster; Now for the Tricky Part

Editor’s Note: Douglas Elliott also participated in a press conference call with Brookings Economic Studies scholars Donald Kohn and Michael Klein on June 18, 2012. Topics covered included what the Greek election results mean for Greece and European countries like Spain and Portugal, how the events might effect the U.S. economy and the G-20 Summit.

Europe dodged a bullet yesterday, as Greek voters narrowly resisted the temptation to elect a government committed to ripping up the agreement with Europe which provides funding for much of their budget. Instead, New Democracy, the center-right party, should be able to form a coalition government with a narrow majority, with the participation of the other traditionally dominant Greek party, the socialist party PASOK. (It is a sign of how far they have fallen that the two parties gained only a bit over 40% of the vote when, for years, they garnered about three-quarters.)

Greeks are torn between several profound but conflicting feelings. On the one hand, they hate the austerity measures contained in the agreement with the “troika” of institutions that provide the bailout funding. They also are very disappointed in the two traditionally dominant parties that got them into this mess and remain quite flawed. These factors pushed many voters to go with Syriza, a coalition of left-wing parties led by the charismatic Alexis Tsipras. Syriza promised to force sharp changes in the agreement with the troika.

On the other hand, Greeks strongly support staying in the Euro. The problem comes because the only way to stay in the Euro is likely to be accepting the existing agreement with substantially more modest changes than Syriza is demanding. (See https://www.brookings.edu/research/papers/2012/05/31-greece-euro-elliott for a much more detailed explanation of the conflict.)

It is good news indeed that Syriza failed to gain the most votes, since they might well have unintentionally triggered a withdrawal from the Euro by being too confrontational with the troika. Such a withdrawal would have put enormous pressure on the rest of the Euro Area which could have led to various disastrous outcomes, including a severe European recession that would trigger at least a modest recession on our side of the Atlantic.

Unfortunately, the new coalition government now faces an extremely tricky set of tasks which it may not be able to pull off. The easiest part is probably getting some interim funding to keep the Greek government from running out of money in July. This is critically important, but Europe is likely to bend over backwards to find a reasonable answer to the short-term crisis, since it really does not want the new government to fall and provoke another election that might well bring Syriza to power. The hard part comes next — finding a new version of the bailout agreement which reflects: the economic reality that no government could meet the current deficit targets; the political need for substantial improvements in the terms to mollify a Greek public that strongly dislikes the current agreement; and the need to avoid all the political pitfalls that exist in the rest of Europe created by fears that the Greeks will just take any additional funding without fulfilling their own promises of reform.

The new Greek government will probably be able to come to an agreement with the troika eventually to significantly rewrite the existing accord. However, this is far from assured. For one thing, all it would take is for a dozen or so members of parliament to desert the coalition government and refuse to accept the necessary sacrifices embodied in a revised agreement. If that happens, the government would fall and would probably be replaced, with or without an election, with a harder line government or political chaos. There are also many political constraints in the rest of the Euro Area that could make a sensible agreement difficult to reach.

Looking beyond this year, Greece continues to face very severe problems that could still conceivably cause it to fall out of the Euro Area. Competitiveness problems have helped create serious trade deficits and many painful structural reforms will be necessary. Greek political and administrative problems will continue to hamper efforts to tackle the budget and trade deficits.

Let us wish the new Greek government well, but remain alert for all the problems still to be worked through there and elsewhere in Europe. Already this morning, Spanish bond markets have come under renewed pressure, even though the Greek outcome was viewed positively by financial markets. (The election came out as the markets had anticipated, limiting the size of the relief rally.)