Reflections on the Situation in Greece

I have recently returned from a trip to Greece and offer these reflections based on many conversations with policymakers and other experts.

1. Basic Overview. After the second elections in June, New Democracy formed a coalition with the Socialist party PASOK and Democratic Left under Prime Minister Antonis Samaras. The government’s first task is to implement the 2012 budget and to close a €11.5 billion gap between their targets and the currently forecast fiscal position. This legislation, now mostly drafted but not passed, is the down payment for renegotiating the terms of their program with the troika, which consists of the European Commission (EC), the European Central Bank (ECB), and the International Monetary Fund (IMF). Rather than a 4.7 percent decline in GDP for this year as envisioned in the second program, the actual decline will probably be in the neighborhood of 7.0 percent. The general government budget deficit, forecast by the Fund in April to be 7.0 percent, will be larger accordingly. Troika representatives are now in Athens for the purpose of writing up a report on the progress of the program. Though it might be wishful thinking, the expectation is that there will indeed be a renegotiation eventually and that this report will be the basis for a third program, concluded perhaps in the early autumn.
2. Program Implementation. The Government in Athens gets credit for labor and pension reform. In addition to closing the immediate fiscal gap and progress on fiscal consolidation, though, the government needs to do product market reforms, privatization, and tax administration. These will probably be necessary to show the rest of Europe that they’ve implemented seriously. The problem of course is that the coalition agreement in June called for not only extending the fiscal targets for two years but also restoring “collective autonomy” in labor contracts, not firing more public sector workers, and capping the income tax at 25 percent of income. So, it is not at all clear how the government can hold together while the troika is simultaneously satisfied. The challenge of implementing the next reforms and the next review by the troika in the autumn will probably be the denouement. Parliament formally serves four-year terms, but the next election could of course come much sooner.
3. Bank Restructuring. This is being organized around the four most viable banks in the system—National Bank of Greece, Eurobank, Alpha Bank, and Piraeus Bank. Some officials in the troika would probably like to simply close Agricultural Bank (ATE) but many Greek officials want it to be absorbed by one of the others instead. Piraeus Bank shows the most interest, but is the weakest of the four. Although there is a commitment to maintaining private control, there is skepticism that this implies an arm’s-length relationship of the banks to the political parties. The troika is searching for the mechanism to ensure that their €50 billion does not simply capitalize piggy banks for the political establishment.
4. Hellenic Financial Stability Fund (HFSF). Greeks are of course hoping to ride in the wake of European movement toward a banking union. Getting the cost of bank recapitalization off of the books of the Greek government would reduce the debt/GDP ratio by nearly 25 percent. Transferring control of the HFSF from the government to the European Financial Stability Facility and its successor, the European Stabilization Mechanism (EFSF/ESM), with direct capital injections, could accomplish this. But there are other institutional mechanisms by which this could be done instead (such as a Special Purpose Vehicle, or SPV) and it would be premature to make the choice now. Greece must first show that it is a “well-performing adjustment program,” in the words of the Euro group, before direct injections can be entertained.
5. Monetary Conditions. Last week, the question arose as to whether Greek banks, now mostly recapitalized, can use the €50 billion in Greek government bonds in their portfolios for regular refinancing operations at the ECB. The Governing Council decided against this for now, pending a favorable review of the troika. But the troika’s report following next week’s visit is not likely to be favorable. Greek banks will thus rely on Emergency Liquidity Assistance (ELA) through the Central Bank of Greece for the time being and will thus pay around 300 basis points compared to 75 for main refinancing operations from the ECB (see "For Greece, ECB = End Close, Beware"). Monetary conditions in Greece will be much tighter than in most of the rest of the euro area. This is perverse, given the depth of its depression, rate of unemployment, further fiscal contraction, and liquidity needs of structural adjustment.
6. Optimistic Scenario. We can conjure one. Direct recapitalization plus serious privatization, could bring down sovereign debt substantially. Expanding the tax base through tax administration would allow us, analytically, to add the black market economy to the denominator of the debt ratio, bringing it down further. Progress on the program and an enlightened approach from the ECB Governing Council would help greatly. Economically speaking, Greece can be rescued; politically speaking, however, it is hard to see how the Greek government, German government, and European institutions play their roles in the scenario.
7. Syriza. The second place finish (27 percent) was the best possible election outcome for this group: It gives breathing space for consolidating their coalition while criticizing the government from the sidelines as the economy worsens. Alex Tsipras, the head of Syriza, is given a chance, at least, of making a party out of the coalition after jettisoning a few of the more extreme members. Another 3 percentage points in the next election would make them the largest party and Tsipras potentially prime minister. Exasperated as they are with ND/PASOK, some troika officials might even see some advantages in this possibility. The pro-European members believe that they have won the internal debate over membership in the monetary union.
8. Euro exit? The incentives are stacked against serious planning for an exit contingency among policymakers in Greece: planning would leak, running the danger of a self-fulfilling prophecy; nobody wants to be responsible for this, given the domestic popularity of retaining the euro; nor does anyone want to make expelling Greece any easier for those in the North who are advocating Greek exit. From this standpoint, and perhaps counterintuitively, confidential contingency planning is risky even though it would probably lower the costs of a possible exit. For its part, German policy is caught in a fundamental inconsistency: Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble cannot credibly threaten Greek exit in order to force adjustment without embracing more quickly the banking and fiscal union that would protect the other members of the euro area from contagion.