Can Greece and the Troika Make the Impossible Possible?

Three scenarios for what could come next in the showdown between Greece's leftist government and its creditors.

Ruling New Democracy Party Hold Election Rally
ATHENS, GREECE - JANUARY 23: Supporters cheer as Prime Minister and leader of the conservative New Democracy party Antonis Samara arrives to deliver a pre-election speech at the Taekwondo Indoor Stadium ahead of the general election on Sunday on January 23, 2015 in Athens, Greece. According to the latest opinion polls, the left-wing Syriza party are poised to defeat Prime Minister Antonis Samaras' conservative New Democracy party in the election, which will take place on Sunday. European leaders fear that Greece could abandon the Euro, write off some of its national debt and put an end to the country's austerity by renegotiating the terms of its bailout if the radical Syriza party comes to power. Greece's potential withdrawal from the eurozone has become known as the 'Grexit.' (Photo by Matt Cardy/Getty Images)

The outcome of negotiations between Greece’s new anti-austerity Greek government and the Troika that is administering their bailout program remains unknown. What is known, however, is that the two sides’ stated goals are mutually incompatible: The Syriza-led government wants debt relief, while the creditors demand repayment. And that means that leading up to February and March, when Greece’s next tranche of money is to be repaid to the International Monetary Fund (IMF) will be very tense. There is a set of mutually agreeable outcomes in there somewhere, even if getting to one of them will be difficult. But the market impact of any outcome will be limited unless Greece defaults and the talk of exiting the eurozone becomes realistic.

It’s important to state two points emphatically from the outset: Greece’s debt burden is economically unsustainable and Greece’s bailout program is politically unsustainable. That’s how this impasse came about. And the fact that the program is totally unworkable should make sense because it was never designed to be workable in the first place.

On Feb. 9, 2010, it became obvious that Greece would default on its external debts. That’s when everyone learned that Greece had worked with Goldman Sachs to conceal the true levels of their debt in order to enter into the eurozone. Before that point, there really wasn’t a crisis and the tone of negotiations was more conciliatory. Afterwards, Greece’s creditors took on a more punitive approach to the situation. And we know exactly how punitive because of a leaked transcript of former U.S. Treasury Secretary Timothy Geithner’s account of the attitude of the creditors at the time.

Geithner recalled a meeting in 2010: “[T]he Europeans came into that meeting basically saying: ‘We’re going to teach the Greeks a lesson. They are really terrible. They lied to us. They suck and they were profligate and took advantage of the whole basic thing and we’re going to crush them,’ was their basic attitude, all of them….”

Greece’s debts — at 175 percent of GDP last year — cannot be repaid. And apparently that was never the goal. The goal was to make any bailout as harsh and onerous as possible as an example to others, such as Spain and Portugal of what could happen to them next. So, now both sides are negotiating a change in this bailout program knowing — though they won’t admit it publicly — that the present program is completely unsustainable economically and politically.

The Greek bailout program is a negotiation in which the two sides can’t afford to simply bluff and walk away. Both the Greek government and the Troika know this and have made extreme statements, suggesting there is a red line that will blow up agreement. This is just posturing, not a reflection on what can actually be achieved in a negotiated agreement. It is in each party’s best interest to make a stark statement, knowing that negotiations are inevitable and unavoidable.

The Troika wants the Greek government’s continued commitment to the bailout program, including meeting budget deficit targets and undertaking labor, pension, and tax reform targets, and privatizing state-owned assets to raise money to meet creditors’ demands. But even if Athens agrees to all of this, the reality is that Greece’s debt burden is simply not sustainable and these goals are not remotely achievable over the long term. And over the medium term they are politically unsustainable, which is exactly why Syriza has come to power.

The Troika’s perspective has three constituent parts: the eurozone’s periphery, the eurozone’s core, and the IMF. Each has diverging interests. This alone means that the Troika’s position will be malleable. But the need for unanimity among the Troika’s members is also a stumbling block; Finland alone could stop an agreement from being reached, not to mention more powerful players in the eurozone. In Germany, for example, even if Angela Merkel is amenable to a debt write-down, her own faction constituents like the Christian Social Union in Bavaria Party may not be. And the German public at large may not be, either. The same is true in each of the 19 eurozone capitals. This limits the Troika’s ability to negotiate a debt write-down.

EU rules set out in the Dutch town of Maastricht more than 20 years ago mandated that getting budget deficits to under 3 percent and moving the government debt burden down toward 60 percent of GDP is a goal for every national government.* But the timeline for achieving this goal is malleable as compromises for Spain, France, and Italy have made clear.

From Greece’s perspective, the new government has run on promises to end austerity as a means of restoring growth. They’ve also promised to fight for debt relief. The biggest constraint here is that it has said it does not intend to leave the euro under any circumstances because Greek citizens still want the euro and because leaving the euro would be a logistical and economic minefield.

Considering these various constraints, both political and economic, what can happen next? It’s impossible to know given the various competing variables. But there are three possible scenarios.

Scenario 1: Negotiated agreement

There are two potential ways the Greeks and the Troika could reach an agreement. In the first, the two sides could decide that they will accept maturity extensions and interest rate reduction without writing down any debt. From the Troika’s perspective, a principal reduction looks to be a non-starter. Finland has said so, and the Germans have said so. They appreciate that the vast majority of Greek debt is in public hands, meaning that contagion from a write-down may be limited. Nonetheless, the ruling coalition in Germany couldn’t likely get approval in parliament or in opinion polls for this kind of move.

On the other hand, the Troika and Athens could institute a program of back-loaded austerity. Although stimulus, which is what Greece wants, is the opposite of austerity, Syriza could still get some stimulus in the short term if they commit to reforms and a plan that has the deficit and debt numbers moving toward the Maastricht criteria over time.

Scenario 2: Default

A default looks likely. This is the main reason the Greek yield curve is inverted, with 3-year debt more expensive than 10-year debt. A deal between Syriza and the Troika seems nearly impossible. And the negotiating tactics the Troika has are not going to be as effective here as they were in the past. For example, they got the Irish to do their bidding by threatening to pull emergency lending assistance from the ECB for Irish banks. They could do the same to Greek banks, but last year Greece began running a primary surplus, which means that it doesn’t necessarily need fresh funding to maintain itself, except to pay interest and principal repayments. It could simply default and meet non-interest obligations indefinitely until the existing debt obligations get restructured. This was always going to be the trump card for Greece. Greece is relatively unique in this regard and the contagion from this scenario would be manageable. So even here, we wouldn’t necessarily see Armageddon.

Scenario 3: Greece exits the eurozone

This is the scenario that is the most fraught with peril. The problem for Greece is that at the prevailing currency level, the country’s productivity levels are too low. In a currency union with western Germany, the only route to success is a combination of transfer payments and internal devaluation i.e. wage and price suppression. When Germany reunified, the eastern states in Germany were able to get there over a 20-year period because of a net migration to the west and huge transfer payments through the German solidarity tax. Even then, the unemployment rate in the east has been crushingly high for most of that period. But the labor migration opportunities within Germany are greater than they are within the EU because of language and culture. And the fiscal transfers that could have are not going to occur. Over the longer term, an internal devaluation across the eurozone is impossible from a social and political perspective. So we could be looking at a eurozone exit then.

The euro is slipping now to $1.12. That should aid Europe to the degree it wants trade with countries outside of the eurozone. But if the Greek crisis grows, then a Greek exit from the euro becomes a viable talking point, which makes a Portuguese, Spanish, and Italian exit a viable talking point. That’s a situation that is disastrous for the euro as a whole. Without the southern bloc, the euro would rise significantly in value, cutting into the ability to export. Germany would lapse back into its soft depression again and France would be forced to think about exiting the euro as well.

The Germans know they have benefited greatly from a weak euro. And so it behooves them to maintain the euro, even if it means giving ground in negotiations with Greece. Right now, Greek markets are in a panic. This could even threaten the Greek recovery. The danger is that the Germans come to believe Greece can be isolated without spillover into the rest of the periphery. This could tempt them to play chicken with Greece. And the potential for a eurozone-wide crisis and market meltdown increases as a result.

Photo credit: Matt Cardy/Getty Images

*Correction, Jan. 28, 2015: Maastricht is a town located in the Netherlands. This piece originally stated it was located in Belgium. (Return to reading.)

 Twitter: @edwardnh

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