Macro and Markets

It is time for banking controls in Greece. Delay at this point will only compound the chaos. Consider the following. Thursday’s meeting of Euro-area finance ministers made no progress toward a deal. That was not surprising. What was more noticeable was the discord that followed. IMF Managing Director Christine Lagarde summed it up: for a Greek deal to happen, there will have to be “adults in the room”. There will now be an emergency leader’s summit on Monday, but absent a major U-turn by the Greek government, that meeting is likely to turn to a discussion of “plan b.” Against this backdrop, there has been a rapid acceleration in outflows from the banking system, reportedly in excess of €2bn in the first three days of week. Deposit flight likely will intensify tomorrow and Monday. The ECB will hold an emergency phone call this morning to decide whether to expand emergency assistance (ELA) to the Greek banking system from its current limit of €81 billion. To keep the banks open, the ECB will need to provide a significant injection of liquidity. They should not do it. Greek banks are clearly insolvent. The crisis has caused a spike in non-performing loans, the economy is deteriorating rapidly, and with the Greek government on the verge of default to the IMF, the ECB can no longer pretend that the Greek government bonds that the banks have provided as collateral for past loans are adequate protection against loss. (Arrears to the IMF do not force other creditors’ claims into default, but the political statement of non-cooperation would be powerful unless serious negotiations are underway.) Further, ready access to central bank liquidity has disabled an important source of market discipline on the government, throws good money after bad, and creditor frustration with the continuing demands for financing make the politics of a deal all the more challenging. The Greek government is likely to resist imposing banking controls, but absent an agreement with creditors controls on deposit withdrawals and cross-border transfers look unavoidable once ECB liquidity support has been curtailed. Controls will buy some time for the government, but how much is unclear. The immediate challenge is fiscal and domestic. The government reported a sharp fall in fiscal revenue last month, reflecting a declining economy and substantial tax non-compliance. In response, it has slashed spending and delayed payments to suppliers and contractors. But large-scale arrears are causing significant payments difficulties in the broader economy, and are not sustainable for long when banks can’t lend. For this reason, I am skeptical that the government can sustain deficit spending for long through creation of IOUs, a informal secondary currency within Greece. How the government responds to these fiscal challenges will go a long way to determining whether controls are a way station to Grexit or, as elsewhere (e.g., Cyprus), breathing space to restructure and adjust within the currency union. My colleague Sebastian Mallaby has an excellent discussion of the perils for Greece of heading down this path, and he makes a convincing case that Grexit is not an easy option. The converse is also true. The international community has coalesced around the policies needed to put Greece on a sustainable path within the Eurozone. That includes additional debt relief and perhaps as much as 2 percentage points of GDP in new measures this year alone—including to pensions, wages, and taxes—measures that the Greek government has firmly rejected and that would be a major economic and political challenge to pass and implement. If Greece were to accept the deal, Europe would need to provide additional debt relief to make the numbers add up, a point recently emphasized by the IMF. Tough decisions are called for on both sides, and the prospect for bridging this gap is looking increasingly remote. While the temptation thus exists to buy time by extending the current program, trading cash for partial reforms, and putting off negotiations on a third bailout until the fall, it is a “bridge to nowhere” if it doesn’t put Greece on a credible path back to sustainable growth.            

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.