Technical talks between Greece and the Troika concluded today without a deal, another setback for Greece as domestic financial stress mounts. Robin Brooks at Goldman-Sachs makes the important point—financial conditions have tightened sharply, and will have adverse and destabilizing effects on growth regardless of whether there is a deal next week between Greece and its European creditors on a reform package. Household deposits in Greece (red line in the left chart) and deposits in non-financial corporations (right chart) have fallen sharply, causing a destructive tightening in financial conditions at a time when banks are already in trouble and constricting credit. (Anecdotal evidence suggests this trend is continuing, with additional outflows from Greek banks in March.) At the same time, a severe squeeze on fiscal resources is forcing the government to make tough decisions about who to pay and who not to pay—which I have called “the politics of arrears”.
Greece: Financial conditions
Source: Goldman Sachs
The experience with emerging markets highlights the high political and economic costs of a financial and fiscal squeeze. In the run-up to Russia’s 1998 crisis, wage and interfirm arrears paralleled a weakening of budget discipline and were reflective of what the IMF came to call a “culture of non-payment” that undermined support for continued adjustment and was an impediment to recovery. In Argentina, after the introduction of banking sector controls in December 2001, financial conditions tightened sharply and arrears at the federal and local level mounted quickly. Paper IOUs issued by governments traded at deep discounts, and eventually most liabilities of the government and private sector were written down at preferred rates as part of an “asymmetric repesofication” by the government. A third example comes more recently from Venezuela, where the moral and political implications of continuing to pay external debt at a time when the government is running comprehensive domestic arrears and rationing foreign currency has generated a firestorm of debate. Weak fundamentals create the conditions for crisis, but payments problems determine the end game.
Robin argues that the risk of Grexit is rising, and I agree; it will become increasingly hard for the government to sustain support for its program and for continued participation in the eurozone as tight financial conditions cause a renewed recession. Recent polls show Greek support for euro membership, but that could change quickly if stress intensifies. So while the long-term sustainability of Greece in the eurozone depends on fundamentals (e.g., a competitive, flexible economy and competitive exchange rate), the decisions the government makes in coming days domestically on payments and banking controls may have more to do with the outcome of the crisis than negotiations with European finance ministers.