Greece’s Bridge to Nowhere

Negotiations continue today between Greece and its creditors, with reports that the government has presented a revised proposal that offers minor concessions in an effort to break the deadlock. A deal is needed in the next week if a package of assistance is to be put in place before end-month payments of $1.7 billion are due to the IMF. While this is not a hard deadline—a short-term default to the IMF need not sink the Greek economy—the government is out of cash and it is hard to imagine how they make critical domestic payments without an injection of cash from creditors.

At times like this, the focus is always on getting a deal done, but this negotiation, even if successful, is likely to defer hard choices for a few months in the hope that Greek domestic politics will change to allow a third bail-out program. The two sides are far apart, both in terms of the policies that need to be taken in the short term and the longer term vision for restoring growth. It is hard not to conclude this is a bridge to nowhere.  A few points.

The two sides are farther apart than the headline numbers suggest. The revised Greek proposal offers a primary surplus of 0.75 percent this year, 1.75 percent in 2016 and 2.75 percent in 2017, compared to the creditor proposal of one, two and three percent, respectively. Seemingly small amounts and one could wrongly conclude the sides are close, but these numbers mask major differences in policy. With current policies, Greece will run a primary deficit this year of around 2/3 of a percent of GDP, and if the government moves ahead with proposed changes to labor and pension laws, the deficit could be substantially larger. Partly this deficit reflects the fall in activity, partly it reflects policy measures from the new government. Thus, even to hit the Greek targets require around 1½ percent of GDP in new measures this year, and substantial additional reforms in subsequent years. This is a lot to ask of a government built on a fragile coalition of interests and elected to do the opposite. Elections have consequences.

The core policies in any deal are well known. Creditors have outlined a set of proposals that will need to form the basis for any deal. They reportedly include: (i) an increase in the VAT, currently one of the lowest in the EU, to raise collections by 1 percent of GDP; (ii) public sector wage cuts of 1 percent annually starting next year; (iii) pension cuts of around 1 percent of GDP by 2017 to put the pension system on a fully-paid basis; (iv) a redesigned social safety net system saving ½ percent of GDP per year; and (v) a labor consultation process that would put the brakes on the government’s efforts to roll back previous labor market reforms. There are also privatization proposals, but the program shouldn’t hinge on that element given the inherent uncertainty and lags involved. Creditors have signaled a willingness to negotiate the numbers, but it is hard to imagine a deal that doesn’t include these elements. The pension issue appears the most divisive, though creditors should be willing to accept a continuing pension deficit if the amounts are made up elsewhere. While pro-growth in the longer-term, these policies are a near-term drag on activity at a difficult time.

To the frustration of Greece’s creditors, the government has failed on multiple occasions to come up with a coherent or well-developed set of proposals to achieve these savings. The revised Greek proposal reportedly focuses on the headline numbers and comprehensive debt relief, instead of the policies. I have long been supportive of substantial debt relief for Greece (and other overly indebted periphery countries), but I also believe that the creditor’s proposals are a reasonable price to ask in return. That is the grand bargain that should be the goal. But while both sides can be criticized, it is hard not to conclude that the government knows what policies are needed to clinch a deal, but that they are simply unwilling or unable at this point to agree to such policies. Perhaps there is a “Hastert rule” in play in Greece, and the government cannot politically go ahead with a program that does not command a majority of Syriza parliamentarians (opposition parties have signaled their willingness to support a deal). The bottom line here is that while the headline differences are small, the policy and political gulf is vast.

The G7 closes ranks. At this weekend’s G7 meeting, there was a strong consensus that Greece needed to make tough and significant decisions to get a deal done.  The United States had in recent weeks been seen to be pressing European leaders to compromise, but President Obama’s statement showed little space between him and the other members of the G7:  "What it’s going to require is Greece being serious about making some important reforms not only to satisfy creditors, but, more importantly, to create a platform whereby the Greek economy can start growing again and prosper.  And so the Greeks are going to have to follow through and make some tough political choices that will be good for the long term."

Domestic payments are still the trip wire. Even if most or all external debt payments were deferred or forgiven, Greece would still need additional resources in the near term while negotiations on a longer term program proceed. A bank run adds to the needs. The government proposes to meet the need through additional treasury bill issuance, which in the end would be financed by the ECB’s Emergency Liquidity Assistance (ELA). ELA exposure to Greece now stands at around €80 billion, and it is understandable that the ECB is wary of being the lender of first resort for an open-ended transitional period. But without this support, growing domestic arrears and missed payments will have a damaging effect on an already slowing economy and put further political pressure on the government. Banking controls inevitably would follow. In the end, non-payment to the IMF need not cause huge dislocations for the Greek economy. Not paying pensions or government wages in full would.

The inflation tax is becoming more attractive. One often-cited advantage from leaving the eurozone is the growth boost that could come from the resultant depreciation, but that presumes that Greece could develop a vibrant non-tourist export sector with a more competitive exchange rate. That is hard to imagine being done easily given current policies. Perhaps a more powerful near-term argument for exit is simply that it relieves fiscal pressure by allowing the government to print money. The inflation tax that results is hugely distortive, but not necessarily more so than the current situation of widespread and growing domestic arrears.

In the end, whether there is a deal or not is a political decision with substantial consequence for Greece and also for Europe. But beyond handicapping the deal, it is important to have a path for Greece that restores growth, and it’s hard to see how we are closer to that outcome now than before the most recent crisis.