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Germany and Greece: In Victory, Magnanimity?



The agreement between Greece and its international creditors announced on Monday represents a predictable capitulation by the Greek government from a position advanced for weeks by Prime Minister Alexis Tsipras. Faced with the dire repercussions of an exit from euro area institutions—including a collapse of its banking system and a broader economic disaster—Tsipras accepted harsher terms than those he had asked voters to reject on July 5.

Ironically, as Tsipras seeks to implement measures that exceed his party's previous political red lines, he may undertake an overhaul of the Greek economy that is more ambitious than anything attempted by his predecessors. As argued by my colleague Angel Ubide, much in the deal is good for Greece. Gone is the fetishistic focus on short-term fiscal targets (though fiscal policy will remain firmly under the control of the creditors). Instead the agreement focuses on reforms of labor markets, product markets, the pension system, the judicial system, the value-added tax, and energy markets, as well as the depoliticization of public administration and banking sector appointments. Last but not least, it calls for a scaled up privatization of Greek state assets of up to €50 billion. While privatization seems unlikely to reach that target, it is likely to involve the sale to private investors of important parts of Greek infrastructure, with important productivity gains as a result.

If Athens does its part, this agreement represents the first potential for normalizing the Greek banking system. If the Eurogroup of finance ministers sign off on the long list of Greek government commitments and legal actions, the European Central Bank (ECB) would raise the ceiling on its emergency lending provision for Greek banks, potentially enabling an increase in the daily deposit withdrawal limit of €60 by Thursday. Full normalization of the operation of the Greek banks will likely require another round of recapitalization. But this ECB action should ease the most acute societal stresses of Tsipras's confrontation with European authorities.

No less important, discussions about future restructuring of the euro area debt holdings for Greece would follow these initial steps. Under the agreement, Greece is expected to "request continued IMF support (monitoring and financing) from March 2016"—that is, after the expiration of the current IMF Extended Fund Facility (EFF) on March 14, 2016. The agreement also states that the euro area will work to ensure that the "Greek sovereign can clear its arrears to the IMF and to the Bank of Greece and honour its debt obligations in the coming weeks to create conditions which allow for an orderly conclusion of the negotiations." Translated into ordinary language, the euro area will provide Greece with the funds to rapidly pay its debts to the IMF, enabling it to once again borrow from the IMF.

But most important, the agreement notes that "in the context of a possible future ESM [Emergency Stability Mechanism] programme, and in line with the spirit of the Eurogroup statement of November 2012, the Eurogroup stands ready to consider, if necessary, possible additional measures (possible longer grace and payment periods) aiming at ensuring that gross financing needs remain at a sustainable level. These measures will be conditional upon full implementation of the measures to be agreed in a possible new programme and will be considered after the first positive completion of a review." Accordingly, an agreement on a new ESM program and a successful first review of Greece's steps clears the way for this discussion. This could well happen in the first quarter of 2016.

The continuing involvement of the IMF ensures that the commitment to debt relief is real. Many critics of the deal with Greece are dismissing or overlooking the fact that debt relief is a more concrete option now than it has been for years. The reason is that without debt relief implemented by March of 2016, the IMF board will rebuff euro area requests for cofinancing a third Greek program. (The first two were in 2010 and 2012.)

In effect, the Fund can compel the euro area to further restructure its Greek debt holdings, if its cofinancing of up to a third of the expected €82 billion to €86 billion (minus any privatization proceeds) is to be granted.1 Thus IMF cofinancing would contribute to the cost incurred by the euro area from restructuring Greek government debt further. It is testament to the short sightedness of the Greek government that it not only failed to see that the IMF could be its greatest ally on debt restructuring but that it even tried to exclude the Fund's participation in the next phase of its program.

If Greece repays the ECB in coming months, and secures additional debt restructuring of the ECB's Greek bond under its Security Markets Program (SMP), it could gain access to the ECB's asset purchase program, a step that would also ease financial conditions in Greece.

Once taken, these actions would provide Greece considerable relief, contrary to the negative publicity surrounding the latest deal. As discussed earlier, Tsipras has a remarkable opportunity to fix the mess he created. By the end of 2015, Greek banks could be on the road to functioning normally again amid serious discussions about further debt restructuring, as Athens has wanted. In principle Tsipras does not have to face Greek voters again until early 2019, after the expiration of the program now being negotiated, and it is not hard to imagine that he could survive with a reputation of turning Greece around.

Tsipras will be helped by several facts. As discussed earlier, polling evidence indicates that he remains the only credible prime minister in any new government coalition in Greece. The Greek population—apparently scared of risking their euros—support parliamentary approval of the new deal by a 70 to 25 percent majority. And the parliamentary opposition should also help—it would be self-defeating not to. Their votes are needed in the likely event of Syriza's own members of parliament voting against the euro area deal. The opposition logic should be to allow a Greek radical left-wing political leader to take the political responsibility for overhauling the Greek economy rather than be on the sidelines criticizing such an overhaul. Over the longer term, the opposition should be willing to join an actual or de facto national unity government to ensure a successful outcome—and share political blame for reforms that may inflict pain in some economic sectors and vested interests.

The most dramatic aspect of the latest negotiations was the bargaining process itself. For the first time, Germany and its allies—seizing on the verdict in the referendum on July 5—explicitly put the option of a member's exit from the euro area on the table. Doing so proved to be an extraordinarily effective negotiating technique, compelling Tsipras to recognize the dangers of going off the cliff with his demands. At the same time, the specter of a Greek exit undermined the sense of irreversibility in the euro area. The claims of Mario Draghi, president of the ECB, to do "whatever it takes" to keep the euro together are hardly strengthened when top elected leaders threaten the opposite. This loss of inevitability to an ever more integrated euro area could complicate ECB monetary policy and its planned exit from the asset purchasing program in September 2016. One result could be financial markets reintroducing some degree of redenomination risk onto the financial instruments of countries going through economic and political turmoil.

At the same time, the danger of a member state exiting the common currency's institutions could lead to financial markets more actively pricing in the tail-end political risk associated with electing parties with policies similar to Syriza's. Bank depositors in other euro area countries, having witnessed the Greek bank shutdown in reaction to Syriza's policies, are also likely to respond to similar political developments in their countries, precipitating bank runs ahead of the election of such parties in the future. These dynamics could warn many voters away from Greek-style radicalism. In effect, Syriza's Waterloo may thus have cast a shadow on like-minded political parties in Spain, Portugal, and elsewhere.

In the newly volatile atmosphere in Europe post-Greece, member states are likely to have to agree to further institutional deepening and handover of national sovereignty—going so far as to likely implement or exceed the recommendations of the recent Five Presidents' Report calling for stronger European financial and monetary institutions .

Indeed, the latest harrowing episode with Greece may actually make future institutional deepening in the euro area politically easier to achieve. True, the crisis reflected Germany's political dominance, moderated by France's willingness to give Greece additional latitude in its program. But the fact that the German government's ill-advised proposal for a potential temporary Greek exit from the euro was dismissed by the rest of the euro area illustrates the limits of Germany's power.

Some final lessons from the latest turn of events: The euro area is first and foremost a rules-based club. The costs of persistently breaking its rules fall overwhelmingly on the wayward member state, especially in self-inflicted crises like Greece's. But this outcome has also contained the risks of moral hazard in the euro area. The Greek case has proven that a member state cannot destroy its own economy in the hopes of securing more lenient support from the rest of the euro area. Consequently, those analysts concerned about the latent threat of moral hazard in a union of partially independent countries should sleep better now. It has become easier for countries like Germany to approach future negotiations about further integration in the euro area with a more open mind and less concern over the potential for moral hazard in any new euro area institutions.

Hopefully for the euro area, Germany and its allies will know how and when to show such benevolence at the current peak of their political influence.


The ESM managing director also made this expectation clear at the press conference on July 19.

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