Greece’s negotiations with its key European funders are not going well. Wednesday night in Brussels, the meeting of European finance ministers reached so little agreement with Greece that they could not even pretend, in the usual diplomatic fashion, that they had agreed on anything. (This follows on the now-classic Berlin press conference where the German and Greek finance ministers could not even agree on whether they “agreed to disagree”).
There is a wide range of potential outcomes over the next six months, and no one’s crystal ball is very good in this unprecedented situation. However, my own base case remains one of strong pessimism about the next few weeks and then optimism beyond that. This is premised on four key assumptions:
- The political and perceptual gap is too wide for negotiators to bridge now;
- There are potential agreements that should ultimately be acceptable to all sides;
- A real breakdown of negotiations would trigger substantial, and growing, harm; and
- The dangers from a breakdown exceed the political pain of an eventual agreement
No agreement is likely soon
There is a fundamental divergence of views between the new Greek government and its negotiating partners. Prime Minister Tsipras leads a Syriza party that came together relatively recently from a coalition of hard-left parties and neither he nor his party members accept the economic and political outlook of the leaders of the rest of Europe. Further, he and his party campaigned on forcing a dramatic change in relations between Greece and the “Troika” (the European Commission, the European Central Bank, and the International Monetary Fund) that has acted as the representative of Greece’s official creditors. Greece wants substantially better terms and an approach to negotiations that fully reflects its status as a sovereign nation, as opposed to a borrower with huge debts. This proposed re-set includes much more control of its choices on how to work its way out of its economic troubles, with fewer dictates and less monitoring.
The new Greek government is extremely popular for its initial steps to “stand up” to Germany and the rest of Europe. A recent poll showed 70 percent approval of the tough line being taken. Prime Minister Tsipras and his Syriza party won the election very recently based on this aggressiveness and have certainly not prepared the public for what would be perceived as a U-turn. None of this suggests that he and his government will move as much as will be needed for a deal anytime soon.
For their part, the other European nations and institutions that have lent Greece over 200 billion euros have a very different view. They insist that Greece abides by agreements reached by the previous government and accepts the overall “program” approach. Greece is to be required to continue to accept strict conditions and to receive funding only as those conditions, such as the implementation of various structural economic reforms, are met. Further, there is a real fear that if Greece is given a much better deal as a result of electing a radical government, this will undermine the establishment parties in Spain, Portugal, Ireland, and even Italy. The core nations in Europe do not want to promote the rise of a series of parties on the “periphery” of Europe that will vie to obtain even better restructurings of their agreements with the Troika.
This gap in interests and perceptions is simply too great to allow an early agreement unless we get very lucky. Further, the Greek Prime Minister has chosen a policy of brinksmanship, on the assumption that Europe is so scared of a potential Greek exit from the Euro (“Grexit”) that it will eventually cave during the negotiations, as would almost certainly have been true a few years ago. This is a miscalculation, as key European leaders are much more confident now of their ability to withstand Grexit and are much more worried about fueling radical parties elsewhere in the periphery if they make too many concessions to Greece. They do not want a collapse of negotiations, but there is a real limit to the price they will pay for an agreement.
The Greeks do have leverage in the negotiations, just not as much as they seem to think. As described below, there would be real harm to the rest of Europe if the negotiations fail. Further, there are geopolitical reasons to keep Greece from becoming too unhappy, including the need for their support for European policies on Ukraine/Russia that require unanimous consent. The Greek public and their leaders have much more sympathy with Russian views than does most of the rest of Europe.
Ultimate agreement is possible
Quite a number of analysts in the financial, think tank, and academic communities have shown that there is a clear middle ground where Greece gains a fair amount of benefit, while Europe holds to the key tenets of earlier agreements, so that both sides can claim victory . Essentially, these potential deals involve some combination of better terms on the official debt, easier near-term targets for government budgets, more flexibility on the implementation of structural reforms, and a change in the formal nature of the negotiating process in the future so that it is no longer officially the “Troika” that is Greece’s negotiating partner, even though in practice these three parties would be key actors.
The economic terms could be improved through further interest rate reductions on the official loans to Greece, further extensions of debt maturities, and possible indexing of a portion of the debt payments so that the timing of repayment is determined by Greece’s economic growth rate in the future. Required primary budget surpluses (that is, the surplus prior to interest payments) would come down from a target of about 4.5 percent in the near-term to perhaps 1.5 percent, rising again over time as Greece recovers.
There could also be a trade-off among structural reforms, as, for example, the new government is highly resistant to further cuts in government employment, but much more open to real implementation of major tax reforms than the preceding government.
A full discussion of the many details goes far beyond the scope of this piece, but the key is that there are versions of a deal in which Greece is substantially better off, even though the outcome is not nearly as good as its initial demands. At the same time, none of Europe’s “red lines” would have to be crossed and there is the possibility of offering some of these same types of changes to other program countries so as not to undermine their existing, cooperating governments. Part of the art, at which the Europeans excel, will be to design the outcome to allow multiple interpretations. The Greeks can claim a great victory while the other Europeans can argue that not very much has actually changed and that they refused to write down debt, back away on structural reforms, or abandon the core of the “program” approach.
Failure would be very painful
It is quite probable that negotiations will break down fairly soon, whether they are formally declared to be dead or it simply becomes apparent that there is an impasse. Seriously bad things would start to happen as a result, with money fleeing from Greece’s banks and from the country altogether as well as households and businesses cutting back on spending and investment. There is a real prospect of further job losses as businesses hunker down. These actions would lead to a new recession if prolonged.
There would also be lesser, but still harmful, repercussions for the Eurozone as a whole, particularly for the vulnerable nations such as Spain. Interest rates would rise in those countries and, eventually, business and consumer confidence would also take a hit, leading to cutbacks in spending and investment in those nations as well. The damage would grow the longer negotiations are broken off and as it becomes more likely that their failure is permanent.
After awhile, Grexit will begin to look like a real possibility, not because the Greeks or the Europeans want it, but because Greece will have to take actions to cope with serious funding difficulties if the rest of Europe refuses to provide new money. This would include the likely eventual issuance of promissory notes denominated in Euros that would, in practice, become a kind of secondary currency that traded at a distinct discount to Euros. (If Greece does not have enough funds to pay its bills and to keep the banks afloat it will eventually have to default, make cutbacks in spending the government is not prepared to make, or use such a quasi-currency.)
A full discussion of Grexit will have to wait for another piece, but my view is that it would induce a serious recession in Greece and less serious, but still quite bad, consequences for the rest of the Eurozone. Europe, and the Eurozone, would survive, but it could push the continent back into mild recession, given how low underlying growth already is. It would also weaken the long-term viability of European Monetary Union, once it becomes clear by example that a nation can fall out of it.
Failure will ultimately look scarier than agreement
A breakdown of negotiations may be necessary to trigger reactions by financial markets, businesses, and households that cause serious pain and make clear that permanent negotiating failure will trigger the bad outcomes outlined above. The Greeks have the furthest to move and probably need to see the prospect of renewed recession and possible Grexit in order to (a) realize that they must compromise considerably more and that brinksmanship is too dangerous; and (b) demonstrate to the Greek public and the core of the Syriza party that failure to compromise would be disastrous. The large majority of Greeks wish to remain in the Eurozone, according to all polls, and it is unlikely that Tsipras wants to go down in history as the man who knocked Greece out of the Eurozone and into a new recession.
One hopeful point is that it does not appear that most Greek voters were that optimistic about what Syriza could achieve in negotiations. They voted for change and hope to see some, but are ultimately likely to accept much less than was originally promised, viewing it as better than nothing.
For their part, the Europeans, particularly some in Germany, are too complacent about the ability of Europe to withstand the exit of any nation, even Greece, from the Eurozone. They may well need to see the beginnings of bad market reactions in the rest of the periphery to remind them of how little we know about whether the “firewalls” would suffice and what the long-term consequences for Europe would be of Grexit. Chancellor Merkel, Germany’s leader, is famously cautious and it is hard to see her insisting on a course that could potentially lead to very bad outcomes for Europe and Germany.
In the end, I believe that both sides will be scared back to the negotiating table and will reach a sensible agreement that will work for at least a number of months before needing renegotiation. However, there are certainly risks that Europe will walk to the edge of the cliff and accidentally fall over this time, rather than stepping back as it has successfully done a number of times during the Euro Crisis.