Europe’s Three-Way Game of Chicken

In the spring of 2012, the mere prospect that the far-left coalition, Syriza, could win Greece’s parliamentary election sent financial markets into a tailspin. Not only did the yield on Greece’s 10-year bonds surge from an already sky-high 20 percent to 30 percent in the space of a month, but the political crisis in Greece infected southern Europe’s other debt markets, from Spain to Italy, because of Syriza’s pledge to “tear up” the country’s 2010 bailout agreement and repudiate Greece’s public debt.

At that time, investors and, more importantly, Europe’s political leaders treated Syriza’s challenge as an outright rejection of the terms of Greece’s membership in the eurozone. The threat of a Greek exit (or “Grexit,” as it has become known) from Europe’s single-currency area — and the financial panic and contagion that stemmed from these fears — nearly blew the eurozone apart. Worries about a messy breakup contributed to the bailout of Spain’s banking sector in June 2012 and fueled concerns about Italy being forced to request aid. The sharp rise in Spanish and Italian yields led to the crucial pledge by Mario Draghi, the head of the European Central Bank (ECB), on July 26, 2012, to do “whatever it takes” to save the euro. His words alone pacified markets and assuaged concerns about an imminent breakup of the eurozone, leading to a renewed surge in investment in Europe and a sharp rally in southern Europe’s debt markets.

But now, after two and a half years of relative calm in Europe’s financial markets, concerns about a Grexit have suddenly resurfaced. On Dec. 29, 2014, Greece’s parliament voted to reject Prime Minister Antonis Samaras’s candidate for the country’s new head of state. Under Greece’s constitution, this triggers a snap parliamentary election that will be held on Jan. 25. The ballot is likely to bring Syriza to power. The radical-leftist coalition is still seeking the same thing it was in 2012: an end to five years of growth-sapping austerity and debt forgiveness by Greece’s creditors.

That these problems have replicated themselves so completely says as much about the enduring political and economic governance problems of the eurozone as it does about the fear that Syriza still strikes into markets. The currency union remains locked in a bitter standoff between a German-led group of countries reluctant to share more financial risks and a French-led one wary of ceding more economic sovereignty.

While Syriza’s leader, Alexis Tsipras, now says he wants Greece to remain part of the eurozone, his party still opposes most of the conditions attached to Greece’s rescue program, from a further reduction in public expenditures to the sale of state-owned enterprises. Syriza’s overriding aim is to secure large-scale debt relief through the outright forgiveness of a significant portion of Greece’s public debt, which still amounts to a staggering 175 percent of GDP — one of the largest debt burdens in the world. This is a demand which Germany has already rejected. Indeed, Greece’s creditors insist the country must adhere to the terms of its bailout agreement if it wants to secure the necessary funding to meet its 28 billion euro debt payments in 2015 and 2016.

Yet if much looks the same as 2012 when it comes to a possible Grexit, some aspects of the situation remain very, very different. The possibility of a Grexit has not forced holders of Spanish and Italian bonds to take fright as they did in 2012. While Greek assets have come under strain — the yield on the country’s 10-year bonds has shot up to nearly 10 percent from just over 7 percent in late November — Spanish and Italian bond yields have barely budged. In fact, they remain at near historic lows.

This is partly because Greece’s public debt is no longer held by jittery private investors and is mostly in the hands of the so-called “official sector,” which includes the International Monetary Fund (IMF) and the eurozone’s own bailout fund. This limits the scope for contagion.

But the bigger reason is that markets now believe that the ECB, which is under significant pressure to help stimulate the eurozone’s depressed economy, is going to launch a program of full-blown quantitative easing (QE), a bond-buying scheme designed to help boost the amount of lending and activity in the economy when interest rates are already at rock-bottom levels, at its much-anticipated policy meeting on Jan. 22. The mere expectation that such a scheme will be announced has already helped push yields on many short-dated European bonds into negative territory.

Yet while Spanish and Italian debt markets are, for the time being, resilient to Greece’s political crisis, the prospect of a Syriza-led government is throwing the deep divisions in European politics into sharper relief. These divisions make it more difficult for the ECB to take the kind of aggressive monetary stimulus measures that the United States Federal Reserve and Japanese central bank have taken in recent years.

With Germany already opposed to any large-scale stimulus program — partly on the grounds that it would relieve pressure on southern Europe’s governments to undertake economic reforms — Berlin is likely to harden its stance further in what is emerging as a dangerous game of chicken between debt relief-seeking Syriza and austerity-focused Germany.

Berlin should be careful what it wishes for. Germany’s negotiating stance is strongest when it is able take a hard line toward Greece without worrying about the risk of contagion to other eurozone countries. Indeed, the resilience of southern Europe’s bond markets has already tempted some members of Chancellor Angela Merkel’s ruling party to claim that Greece no longer poses a threat to the stability of the eurozone, suggesting that a Grexit would be more manageable this time around. (While Spanish and Italian bond markets may be a lot more resilient this time around, they would almost certainly come under more pressure if Greece were forced out, creating a dangerous precedent for other countries, like Italy, that may be tempted to do the same.)

While this is mostly brinkmanship ahead of Greece’s election, it is loose talk given Germany’s opposition to a program involving major purchases of government bonds by the ECB, the expectation of which is the main reason why Spanish and Italian debt markets have remained calm.

If its opposition to full-blown QE undermines the perceived credibility of such a program — and there are signs that this has already happened, with the ECB likely to be forced to make a key concession to Berlin in which the bonds of respective eurozone countries will be bought by national central banks — then it will cause market sentiment toward the rest of southern Europe to deteriorate, making it more dangerous for Berlin to clash with a Syriza-led government. Fears about a Grexit would become more intense and the eurozone could once again be at risk of suffering the turmoil of 2012.

The only way forward appears to be some form of grand bargain in which Greece’s creditors grant Athens meaningful debt relief in exchange for a commitment from Syriza to stick to the path of economic reform. This could involve a much longer extension of the maturities on Greece’s debts and cutting the country more slack on fiscal policy in exchange for the swifter implementation of structural reforms, such as curbing tax evasion. Yet even this would likely prove difficult and involve months of political uncertainty, given that Syriza is unlikely to prove as pliant and pragmatic as markets expect, while Berlin will be wary of granting Greece concessions that could embolden other anti-austerity parties in Europe — in particular the far-left Podemos party in Spain.

Investors are hoping that ECB President Draghi will save the day by devising a QE program that is both acceptable to Germany and large enough to pacify markets. This could involve significantly larger purchases of government bonds than the 500 to 600 billion euros expected by markets in exchange for much more limited risk-sharing.

Yet what matters most right now is whether Tsipras and Merkel can find a mutually acceptable compromise in which Syriza moderates its stance on economic policy and Germany agrees to meaningful debt relief for Greece. The jury is still very much out on this.

ARIS MESSINIS/AFP/Getty Images