Europe

Thursday’s Brexit vote wasn’t a “Lehman moment”, as some have feared. Instead, it was a growth moment. And that may be the greater threat. If policymakers respond effectively, the benefits could be substantial: a stronger global economy, and an ebbing of the political and economic forces now pressuring UK and European policymakers. Conversely, failure to address the growth risks could cause broader and deeper global economic contagion. In the immediate aftermath of Thursday’s vote, there were significant concerns that Brexit would generate a market reaction similar to what we saw following the fall of Lehman Brothers in August 2008. Market moves in the immediate aftermath of the vote wiped around $3 trillion off of global equity markets, mostly in the industrial world. Indeed, foreign exchange markets (and some equity markets) saw larger moves than after Lehman’s collapse, before finding a degree of stability today. Yet, by all accounts, markets moved smoothly and cleared, there were few reports of payment and settlement issues, and little evidence of financial distress affecting counterparties. No doubt, news may emerge in coming days of large loses taken by some over-leveraged investors, and periods of intense volatility are more likely than not. So we should see today’s bounce as a temporary calm, not the end of the storm. But, if we define a Lehman moment as a comprehensive breakdown in trust in markets, a collapse in creditworthiness and confidence that cascades through financial markets as we saw in 2008, then Brexit is a crisis averted. Central banks deserve a great deal of credit on this score.  According to reports, the major central banks, led by the Bank of England, had been war-gaming a Brexit vote for several weeks, talking to market participants, and stress testing banks and markets. BoE head Mark Carney had his version of ‘whatever it takes’ remarks early on Friday, and provided ample liquidity to markets (in both pounds and sterling).  The Federal Reserve, European Central Bank, and other central banks made statements of support. The broader concern for markets, and for policymakers, is growth. For the United Kingdom, which before the vote was expected to grow on the order of 2 percent, the shock will be severe, perhaps on the order of 2-3 percent over the next 18 months. Some market analysts are predicting an outright recession given the substantial political and economic uncertainty that has been created and its likely effect on investment and consumer demand. The exchange rate depreciation will over time provide a powerful offsetting boost, as will expected rate cuts from the Bank of England, but will take time to be felt. First and foremost, this is a UK shock. The more difficult question is the extent of contagion to the rest of the world. The sharp rise in the yen has intensified concerns about Japanese growth, and put pressure both on the Bank of Japan and the government to introduce additional stimulative measures. But looking beyond the immediate cyclical considerations, Europe poses the more significant concern, given the weak state of the region’s economy (and a population increasingly frustrated with their economic prospects). As in the United Kingdom, uncertainty about post-Brexit relations is likely to weigh powerfully on investment. Relatedly, it is not surprising that European bank stocks fell sharply after the vote, given a continental banking system struggling with the legacy of the crisis and weak profitability.  Lower interest rates will not help on that latter score.  The ECB can ensure adequate liquidity to troubled banks, but can’t make them lend. If Europe wants above-trend growth in this environment, fiscal policy will need to do more. My colleague Sebastian Mallaby has a sensible set of recommendations, starting with a German tax cut, but his proposals seem politically quite challenging. Failure to act may not lead to an immediate economic crisis, but a weaker European economy makes the politics of preserving the European Union all the more treacherous. The dog that hasn’t yet barked is the emerging markets, which have held up well in recent days.  In part, this reflects that commodity prices and Chinese growth, the two most important drivers of EM prospects, have strengthened in recent months and, at least compared to the start of the year, there was a buffer to absorb this most recent shock.  Also, many emerging market investors pulled back on risk before the vote.  Tax measures in some countries (e.g., South Korea and Indonesia) have boosted confidence. Perhaps most importantly, the decline in interest rates in the United States, and the associated decline in expectations that the Federal Reserve would hike rates, matters a great deal for these markets. Still, if doubts about any of these supports were to arise, particularly Chinese growth, then a European regional shock could become global quickly. Finally, in the United States, most analysts (and the market more generally) now expect the Fed to delay a tightening till the end of the year, if not cut interest rates. The prospect of a significant strengthening of the dollar will cause a drag on growth, but given normal lags the brunt of any dollar move will not be felt on the economy till 2017. Unfortunately, the political consequences of a dollar spike on the election campaign is far more uncertain, and potentially more immediate. Those who believe that the populist anger we saw in the UK will be mirrored in the U.S. elections will see opportunity here.  This may be the most worrisome source of contagion from Brexit.

Britain’s vote to leave the European Union was fueled by a broad range of social and political concerns, including a fear of immigration, resurgent nationalism, and a populist rejection of UK and European policies, institutions and policymakers. But is also an extraordinary economic experiment. Here are a few things to look for in coming days as the global economy tries to absorb the implications of this leap into the unknown. A sharp market jolt, followed by extreme volatility Pound sterling was in the vanguard of the market reaction. After reaching 1.50 against the dollar yesterday on hopes of a remain vote, the pound fell to 1.33 before rebounding to 1.37. Global equity markets also have fallen sharply this morning, partly a reflection of how unexpected the result was and partly a natural pulling back in risk taking in the face of uncertainty. The biggest falls were outside the UK, in Europe and Asia, and U.S. futures predict a significant decline here. It is often noted that, initially, little changes in the fundamentals of the British economy. It could be several months before Article 50 of the EU treaty is invoked by a new British prime minister, beginning the formal process of withdrawal that would take at least two years, and likely more. For now, the way Britain moves, works and trades will not change. Still, the uncertainty about what follows, and the potentially protracted political debate that follows, is likely to contribute to an elevated level of market volatility. Weaker levels for the pound, and equities, seems more likely than not. Central banks show the flag The Bank of England quickly announced its commitment to “take all necessary steps to meet its responsibilities for monetary and financial stability” and indicated that it had provided significant amounts of dollar and pound liquidity. A number of other central banks have confirmed intervention, and globally this shock likely will be a reason for monetary policies to remain accommodative in coming months. As it has been in this recovery, the burden of driving economic recovery falls fully on central banks. Aggressive central bank action can go a long way to addressing liquidity concerns in markets, but what it can’t do is fix underlying concerns about the health of the European financial system. We should be worried about what a shock to growth, and the asset price moves we are seeing, mean for the longer-term viability of European banks that are already struggling to achieve profitability and deal with the legacy problems from the earlier crisis. Concerns about specific financial institutions in the UK and Europe could emerge in coming days and perhaps represents the bigger threat to market stability. A UK economic stall, which will be felt globally. Market analysts predict a sharp fall in UK growth over the next year, on the order of 1-2 percent lower, with some predicting an outright recession. At the same time, the rating agencies have signaled that they are likely to downgrade the UK. Uncertainty will be felt on investment most importantly, as well as consumer sentiment. Even if you are optimistic about the long-run future of the British economy outside the EU, the cyclical effects appear likely to be significant. The shock will drag European growth lower, adding to political strains on the union. I expect Grexit will again return to the front pages of the newspapers, along with calls for referendum elsewhere. A drag for the Fed The fallout from the Brexit vote in the United States--tighter financial conditions caused by weaker stock markets and reduced risk taking, uncertainty about the future of Europe and global trade, as well as a weaker outlook for growth, strengthens the case for the Fed to put off rate hikes (if they needed any reason beforehand). Many issues that have come to the fore in our election campaign, including anxiety about the economic future of the country and globalization, will get a new look today. Together, there are many reasons to believe the economic consequences for the United States could be significant. Again, Britain punches above its weight.

A few weeks back, the New York Times looked at the “mystery” of Spain’s high level of unemployment. The article highlighted a real debate about the right level of job protection in Spain, and in Europe. But the headline obviously stuck in my mind. I do not think there should be any significant debate over why Spain continues to have a very high level of unemployment. Look at employment. It is down well over over 10 percent from its pre-crisis levels. Even with the current recovery, there are over 2.5 million fewer people at work in Spain today than in 2007 (18 million versus 20.7 million workers over age 15 using the harmonized EU data; the national data has a similar change but a slightly higher level) And domestic demand is also down well over 10 percentage points. No mystery.* If demand in the United States was 10 percent below its 2007 level, rather than roughly 10 percent above its 2007 level, I would certainly hope that there would not be much of a debate on the source of a weak labor market. Spain did have a rather high level of unemployment back in the 1990s. Yet when demand was strong, folks were pulled into the labor market. Joblessness fell. From 2005 on, Spain’s labor market institutions were consistent will unemployment rates of well below 10 percent. And—unless the stories European policy makers tell themselves are off—Spain’s labor market institutions should work better today than they did prior to the crisis. It is thus hard to see changes in labor laws since 2005 can explain why there are fewer people working now than in 2005. That gets at the critical issue. The kind of structural reforms that facilitate an internal devaluation have an ambiguous impact on employment, especially in the short-run—a point now recognized by the IMF. Lower wages increase competitiveness, and support exports. But lower wages also mean less demand throughout the economy. Spain’s case is particularly striking (Matthew Klein’s overview is still among the best places to start). Exports have done relatively well. They have added a cumulative 6 percentage points or so to Spain’s GDP since 2007. Spain is not Greece, which has struggled to raise overall exports even with a big fall in wages. Thanks to what in the United States would be called transplants, Spain produces more cars than any European country not named Germany. More than Britain, France or Italy—all bigger economies. Spain now produces over 2 million cars a year, and about 2.75 million cars and trucks. But there are still over half a million fewer jobs jobs in Spanish manufacturing than there were back in 2007. One reason: Internal car sales are now only 1 million or so. That is well above lows of around 0.75 million a year, but still down significantly from the pre-crisis level of 1.5 million a year. And more broadly, the change in “jobs” still tracks changes in internal demand not changes in exports, or the change in GDP. I measured all the real variables as contributions to GDP—and did the absolute change in jobs. But choosing other scale variables doesn’t change the story. Changes in demand and changes in jobs map to each other.** This shouldn’t be a surprise. The export sector is generally more productive than domestically facing sectors. So it takes a really large expansion of exports to generate enough jobs to offset the fall in jobs from a large fall in internal demand. Exports would need to be up by closer 15 percentage points of GDP not 5 percentage points of GDP to offset the jobs impact of an over 10 percent fall in domestic demand (even taking into account the fall in imports). Job creation through internal devaluation and demand compression has proved to be a very difficult policy to pull off, especially inside a currency union where the stronger economies are themselves not generating large wage or price rises. Spain ran a large current account deficit prior to the global crisis and needed to reorient its economy toward exports. And to a significant degree it has done so. But that alone cannot easily compensate for the jobs lost from the fall in internal demand. Spain needed—and needs—policies in the euro area that would make adjustments in relative wages and prices possible without outright falls in Spanish prices and wages. That would allow external adjustment with less internal demand compression. And then there is the question of fiscal policy. Spain still runs a sizable fiscal deficit, around 5 percent of GDP. Domestic demand would be far lower than it is without that deficit. Yet there will be pressure to push any new Spanish government to bring that deficit down to meet European fiscal targets. And the best conceptual option—finding a way for demand supporting policies to be funded by the euro area as a whole—is not on the table. * Peter Eavis of the New York Times obviously did not choose the headline on his article. And his article mentions the broader European debate on supporting demand versus prioritizing structural reform. But the emphasis was on demand-promoting policies by the euro area as whole. The variable that was left out, in my view, was Spain’s own level of demand. ** Greek employment is also down around 20 percent. But in Greece’s case the fall in jobs has been more moderate than the brutal fall in overall demand.

Five experts analyze the potential impacts of a UK departure from the European Union on economic growth, financial stability, and foreign policy.

Last week, Greg Ip of the Wall Street Journal argued that Germany should focus on raising private wages rather than increasing public investment as part of a broader critique of Germany’s inclusion on the Treasury’s enhanced monitoring list. Ip: “Germany’s problem isn’t the public sector, it’s the private sector: Businesses need to invest more and workers need to earn more, and that can’t simply be fixed with more government spending.” I have a somewhat different view: more public investment is a key part of the policy package needed to support German wages. Ip is certainly right to highlight that Germany gained export competitiveness by holding down wage growth during the ‘00s. Wages and prices in Germany rose by a lot less than wages and prices in say Spain from 2000 to 2010, contributing—along with rise in global demand for the kind of high-end mechanical engineering that has long been Germany’s comparative advantage—to the development of Germany’s current account surplus. And that process now needs to run in reverse for Germany’s euro area trade partners to gain competitiveness relative to Germany. See Fransesco Saraceno, or Simon Wren-Lewis. But the changes in German wages and consumer purchasing power needed to allow Europe to rebalance up, with shifts coming from strong wage and demand growth in Germany rather than weakness in wages and demand elsewhere, will not occur in vacuum. To state the obvious, for Germany’s substantial external surplus to fall either exports need to fall or imports need to rise. For Germany’s workers, many of whom work in the export sector, to have the confidence to demand higher wages while exports slump they need confidence that domestic demand growth will be there. Put differently, low nominal (Bunds out to 8 years have a negative rate) and negative real rates only will push up wages if either the private or public sector respond to low rates by borrowing more. The domestic side of Germany’s economy may need to run a bit hot to pull workers out of the export sector. That isn’t happening now. Wage settlement in Germany was weaker this year than last. Nominal wage growth of around 2% in 2017 in Germany would not create much scope for others in Europe to regain competitiveness without wage deflation. And there is abundant evidence that Germany needs more public investment. Public investment in Germany has long been lower than the euro area average (under 2 percentage points of GDP, versus say 3 in France). Many of Germany’s roads and bridges—surprisingly to some—could use a makeover. Investment in public capital has not covered depreciation; keeping a high quality stock of public infrastructure means making the investment needed to maintain it. See the Elekdag and Muir IMF paper, or Hans-Helmut Kotz “Relative to the early 1990s and in constant prices, capital expenditures are down some 15%. For more than a decade now, they have not sufficed to maintain the capital stock. This is not preparing for the future; it is undermining productivity and well-being. .... crumbling infrastructure (admittedly not as bad as in the US) has become a real issue in Germany.” Raising public investment is almost a free lunch. The market is paying Germany to borrow, more or less. Public investment creates needed new capital that should raise potential growth, and thus could well improve long-term public finances. And in the current context, there is a good case that public investment would crowd in private investment even as it pulls in imports. What is not to like? Ip argues that the IMF study showing that a 1 percent a year increase in public investment (when at the zero bound, to be precise) “only” reduces the current account by 0.5 to 0.6 percent of GDP is a reason not to raise public investment. I would argue it the other way. The projected impact on the current account is actually quite large. Most policy changes have a much smaller impact on the external account.* To get a bigger impact that this in a standard model you need a major change in relative prices (e.g. a change in the exchange rate). And for that matter, if Germany’s current account is too big, real interest rates are negative and private savings far exceeds private investment, why be limited by a percentage point a year increase in public investment for two years as the IMF sort of suggested? I jest of course; political reality intervenes. Germany’s governing coalition has made the black zero (the schwarze Null) the central goal of economic policy. And since Germany is projected to move from a fiscal surplus of just over half point of GDP to rough balance thanks to spending on migrants, even a 1 percentage point increase in public investment now seems off the table. But we should be analytically clear: Germany’s commitment to fiscal balance makes it harder to bring its current account deficit down. If a country with a large external deficit was running a large fiscal deficit, would the IMF say that they should not cut their fiscal deficit because it would “only” reduce the current account surplus by 0.5 percentage point of GDP? Certainly not. So why the reluctance to encourage fiscal expansion in a country with a massive external surplus, negative real rates, and a tight fiscal policy relative to its trading partners? The asymmetry Keynes highlighted—there is more pressure on deficit economies than on surplus economies to adjust—is alive and well. * Consistent with the IMF’s “It is Mostly Fiscal” reputation. the IMF’s global model for the current account has a relatively high coefficient on the fiscal balance, especially after most recent revision to the model raised the coefficient a bit, while things like intervention in the foreign currency market have almost no impact. The IMF generally finds that a 1 percentage point change in the fiscal balance has an impact of between 0.45 and 0.5 percentage points on the current account.

I stopped blogging almost seven years ago. My interests have not really changed too much since then. There was a time when I was far more focused on Europe than China. But right now, the uncertainty around China is more compelling to me than the questions that emerge from the euro area’s still-incomplete union. Some of the crucial issues have not changed. The old imbalances are starting to reappear, at least on the manufacturing side. China’s trade surplus is big once again—even if the recent rise in the goods surplus (from less than $300 billion a couple years back to around $600 billion in 2015) has not been matched by a parallel rise in China’s current account surplus. The U.S. non-petrol deficit is also big, and rising quite fast. But some big things have also changed. The United States imports a lot less oil, and pays a lot less for the oil it does import. That has held down the overall U.S. trade deficit. Oil exporters have been facing a gigantic shock over the last year and a half, one that is putting their (sometimes) considerable fiscal buffers to the test. Even if oil has rebounded a bit, at $50 a barrel the commodity exporting world is hurting. Looking back to 2006, 2007, and 2008, one of the most surprising things is that Asia’s large surplus coincided with rising oil prices and a large surplus in the major oil exporters. High oil prices, all other things equal, should correlate with a small not a large surplus in Asia. The global challenge now comes from the combination of large savings surpluses in both Asia and Europe rather than the combination of an Asian surplus and an oil surplus. And, well, China’s surplus is rising not because its exports are growing fast, but rather because its imports are falling more than its exports. And not just its petrol import bill. Actual imports. For 2015, and looking only at goods, China’s import volumes were down 2 percent year over year. Export volumes were flat year over year. China’s manufacturing surplus is stable, but at a high level (just under $1 trillion a year). China’s commodity import bill is falling fast, and that has pushed the goods surplus back up to record levels. A huge (and to my mind hugely suspicious) surge in tourism spending though has offset some of the rise in China’s goods surplus in the current account. The global challenges that come from a large surplus that reflects weakness rather than strength are in some ways more complex. The fix for China’s outsized trade surplus back in 2007 was conceptually simple: China had to stop intervening and let its currency appreciate. China’s economy was over-heating, so a stronger currency would have helped maintain domestic balance. Back in 2007 and 2008, China clearly had the capacity to take its foot off the various brakes it was applying to domestic activity if it got less support from exports. Now if China stopped intervening its currency would likely fall and its already-large trade surplus would—assuming that the second order effects of the resulting depreciation on the rest of the world were not too big—rise even more. And the policy tool that most obviously would bring China both toward internal and external balance—expansionary fiscal policy done by the central government and on its balance sheet—still faces internal opposition. Borrowing by the central government to provide policy support for household consumption isn’t the same thing as borrowing by local governments to finance a splurge in investment or borrowing by a state firm to build new steel capacity. But sometimes those differences seems to get lost. It is easy to say that the solution to too much debt is not more debt. But sometimes the solution to too much debt in one part of the economy is more borrowing in another part of the economy. And, well, the techniques that helped me “see” the global flow of funds across borders back when a large share of global flows were being intermediated through the balance sheets of a small number of emerging market central banks, which were reliably adding $1 trillion plus to their reserves a year, no longer work that well. Back when the PBoC was buying a lot of U.S. treasuries and agencies, it was in a deep sense too big to hide. “Belgium” almost certainly didn’t buy $200 billion in U.S. treasuries between the end of 2012 and the end of 2014, and it equally didn’t sell $200 billion in U.S. treasuries last year. Chinese citizens are on net still buying a lot of foreign assets, even if China’s government sold reserves in 2015 at a pace that was almost as fast as it once bought the reserves.* That is what a $300 billion a year current account surplus means. And I suspect some of the surge in spending by Chinese tourists is going into financial assets, and thus the real current account surplus is a bit higher. But private capital outflows from China—and for that matter private flows from other important economies, like Russia—never have really showed up cleanly in the TIC data. So to an important degree I now feel like I am flying blind. Flows through banks are a bit harder to track than flows through the bond market. I am excited to be back at the CFR, and to restart this blog. I hope that there is still an audience for opinionated, but hopefully (largely) data-driven analysis of the global economy and the global flow of funds. *In dollar terms the pace of sales was a bit faster in 2015; as a share of GDP, the purchases back in 2007 and 2008 were far larger.

The twin bombings in Brussels have exposed the need for closer European security cooperation at the same time that anti-EU political forces are on the rise, says expert Ian Lesser.

My latest global economic monthly looks at rising economic populism in Europe and how it constrains the capacity of policymakers to get a robust recovery going and deal with shocks. Some of the drivers of populism—on the left and right, in creditor and debtor countries—are cyclical but many including globalization, income inequality and insecurity are likely to be more persistent and resent a long-term threat to greater European integration. The strong showing of the National Front in last weekend’s French regional elections, Denmark’s referendum rejection of further EU integration, and Britain’s debate over its EU future are recent reminders of the fraying consensus on further integration, which has strong implications for economic cooperation. Easy money from the European Central Bank (ECB) can only do so much, and a broader policy response including a faster pace of economic integration and more flexible fiscal policies now are needed.

Markets were clearly underwhelmed by the European Central Bank’s (ECB) easing announcement yesterday, marginally cutting its (already negative) deposit rate and extending the duration of its asset purchase program (QE). I think the Financial Times had it about right. It would have been better to do more, but what they did was helpful and it retains the capacity for further action. Still, as Ted Liu and I argued yesterday, the main channel through which QE is going to boost activity in Europe (as the Federal Reserve normalizes) is through the exchange rate, which in the context of weak global demand and emerging market capital outflows may be a modest source of stimulus. The market reaction also underscores the challenge for a central bank to communicate its intentions when the governing council is divided and it is trying to be data dependent--i.e., it is hard to communicate what you don’t know. We also agree with the FT’s bottom line: at this time, monetary policy alone cannot be expected to carry forward a robust European recovery.  Fiscal and structural policies must do their part.

At the governing council’s meeting today, the European Central Bank (ECB) announced that it will cut benchmark deposit rate to -0.3 percent, extend its quantitative easing (QE) program to at least March 2017, and broaden the scope of assets purchased. On several occasions since October, ECB President Mario Draghi has hinted an easing was coming, stating that the central bank will do what they must to “raise inflation and inflation expectations as fast as possible.” There is a strong economic case for action: inflation has stalled at levels well below the ECB’s target inflation rate of below but close to 2 percent (headline inflation in October was 0.1 percent), growth remains weak, and unemployment rates are still sky high. But, as in the United States, there are growing doubts about how much a boost of QE will provide to the European economy. A few thoughts on why the ECB’s move still matters. First, as much discussed, the ECB’s further monetary easing will clearly begin a period of policy divergence with the Federal Reserve’s normalization of interest rates widely expected to begin this month. Given the different cyclical positions of the two economies, such divergence was inevitable, and I have previously argued that China-induced market volatility should not be a reason of indefinite inaction. Even after the Fed hikes, U.S. monetary policy will remain easy by any of a number of policy rules. Still, a divergence of this magnitude is likely to continue to exert appreciation pressure on the U.S. dollar against the euro. Euro depreciation now appears to be the primary channel through which QE will boost demand in the euro area through improved trade competitiveness. The other central transmission channel, through additional bank credit, appears more muted in Europe than in the United States (my sense is that much of the improvement in credit numbers in recent months reflects the natural healing of the European economy, though QE no doubt has played a role). More broadly, euro depreciation will add to the external pressures on emerging markets by reducing demand for their exports at a time of continuing financial outflows. Meanwhile, in the United States, the political implications of a stronger dollar could also be profound during the election cycle if the euro continues to depreciate. There is also a sense in which today’s decision represents a turning point, the end of a period when the ECB (like the Fed and the Bank of Japan) has been the dominant source of discretionary macroeconomic policy. This is not to say that the ECB is out of options—interest rates could be made more negative (though perhaps at a cost in terms of increased financial stability risks). Further, the proposal that some have made for the ECB to purchase equities and non-securitized debt is a bridge too far for now, but remains a “break glass” option. Still, it now appears that we are at a stage where further ECB options will have uncertain and potentially modest effect on activity, and where its decisions could become a source of greater unity or disunity in the euro area. For example, with the expansion of the program, ECB may soon run out of German or French bonds to buy, and have to resort to the bonds of bailed-out countries such as Ireland, Spain, and Portugal. This expansion could prove politically challenging, as fiscal disciplinarians (e.g., Germany) and populist governments (e.g., Finland) may argue against providing these former crisis countries with cheap financing. A lot has been asked of ECB, and today’s move will be closely watched within and beyond Europe. The decision will be an important step in determining whether the region will soon return to a more sustainable growth trajectory in the next year. Still, at a time of rising global risks, lackluster growth and bailout fatigue in the region, and economic populism is rising across creditor and debtor countries, fiscal policy and the continuing efforts to advance economic union in Europe now will need to become a more central focus.

It should be no surprise that eurozone finance ministers failed to agree to disburse €2 billion in bailout money to the Greek government today or to release bank recapitalization funds. Despite optimism following the recent announcement of a relatively benign program for recapitalizing Greek banks, it is hard to escape the conclusion that the Greek program again is headed off track.  The government has fallen behind its reform commitments, and a substantial number of additional end-year measures look unlikely to be met. Even with substantial forbearance from Greece’s European partners, it now looks likely that conclusion of the first review of its program will be delayed and that the promised debt relief negotiation will come only in 2016. Further, an eventual International Monetary Fund (IMF) program is likely to be small and leave a large unfilled financing gap that will further strain Greece’s relations with its European neighbors.  It is hard to predict how long Greek voters will continue to support a government that cannot deliver on its economic pledges of low debt and sustainable growth. The European Union (EU) bank audit results revealed a capital need of €14.4 billion in an adverse scenario (€4.4 billion in the baseline), which conveniently looks to be consistent with previously approved bank recapitalization funding from the Hellenic Financial Stability Fund (HFSF). While the downside scenario is not an exit scenario—the capital needs would likely be far greater if Greece were to exit the eurozone (and Greek bank capital still relies on deferred tax assets to an excessive and credibility-destroying extent), it does cover a substantial renewed recession that would result from a protracted standoff with the IMF and its European creditors. The push is now on to complete the recapitalization by year end, raising private capital to the extent possible before state aid is drawn on, before new EU rules go into effect that would require a greater haircut on bank creditors as a condition of state support (there is a certain irony in hearing policymakers celebrate the evasion of these new rules once seen as critical to the credibility of EU banking union). The next step in Greece’s reform effort is the first review of the August European Stability Mechanism (ESM) program, which is a condition for further disbursements under the package and, more significantly, required for starting the negotiation of debt relief. Reports today suggest disputes remain on a new foreclosure law, the VAT on private education, and pricing of non-generic medications, as well as on the timing and pace of pension reform.  Individually, each of these problems would appear solvable if the government has the will to move forward, but the growing list of unmet commitments has raised concerns among creditors as has the request by the Greek government for a "political decision" on the review. Much was made over the summer on the dispute between the IMF and Europe on debt relief for Greece, The United States now is also pressuring the eurozone on debt relief for Greece. While the announcement of debt relief could maintain domestic support within Greece, the ultimate success of the program is still uncertain. Whether Greece receives haircuts (what the IMF and the United States would like to see) or further deferral of interest payments (the German proposal) will only affect what Greece has to pay after 2022.  In any event, the extended window of very low debt payments to official creditors creates temporary space for private issuance, but this type of seniority-driven market access is not durable and will require repeated official debt service extensions. Despite this issuance, in the near term there would appear to be substantial funding needs for the Greek government.  The fiscal position has returned to deficit (taking into account accumulated arrears) and growth is likely to remain muted at best.  The current IMF forecast is for growth (year-over year) to turn positive only in 2017. It is easy to be critical of a reform program that contains so many reform measures, and arguably a lack of institutional capacity within the Greek government limits their capacity to move forward. But at the same time, there cannot be a return to durable growth within the eurozone without a major transformation and opening of the Greek economy, and creditors are increasingly frustrated with the slow pace of the Greek government in meeting its commitments.  Ultimately, “Grexit” will become an option again when Greek voters lose patience with the current path being charted by the government.  It is hard to predict when it will happen, but hard to imagine another result.

  The Greek elections on Sunday returned the Syriza-led coalition government, a modest surprise following polls showing a close race that might have left a deadlocked parliament. Most commenters took the result as positive for Greece’s reform effort.  Certainly, the government now has a strengthened mandate to implement the program that it agreed to in August.  The program’s first review, now likely in November has some tough issues (e.g., pensions, banking recapitalization) but disagreements are likely to be navigated, setting the basis for a negotiation on debt relief and the terms of an International Monetary Fund (IMF) program.  Most importantly, the ongoing European immigration crisis and other pressures on European decision making (e.g., “Brexit”) likely have reduced the appetite of even Greece’s toughest critics for a confrontation with the government.  All this points to the needed forbearance to keep the program on track. There are a few reasons for caution, which provide perspective on why I still believe that ultimately “Grexit” remains the most likely outcome and the best chance for Greece to restore growth over the longer term. Pensions and banking.  First review of the European Stability Mechanism (ESM) program will see the government pushed to take further steps on pension reform, one of the toughest areas politically for the Tsipras government.  On the banking side, there are significant differences over the size of the bank recapitalization (the IMF reportedly would like to see a larger recapitalization than what the Greek government has called for, hoping to provide a buffer against future downside risks). Fiscal slippages and financing.  While anecdotally, there has been a pickup in tax collection, the August data shows that revenue remains 11.9 percent below target.  Fiscal targets are being met overall, through a massive reduction in spending that is unlikely to be sustainable.  Part of this improvement, further, relies on cash-basis accounting, and the likely continued accumulation of arrears flatters the books. Given the economic carnage associated with the showdown with creditors this summer, there likely will be slippages from what was assumed and there will be a difficult debate over whether Greece should be required to take additional austerity measures. Official creditor disputes.  If Greece is not required to take additional fiscal measures, and as a result the financing required for the program exceeds the predicted €86 billion, then who will pay?  The IMF has already signaled their willingness to lend depends on “explicit and concrete” debt relief from other official creditors, an argument that I have linked to a desire to limit their own financing.  Without a long moratorium on repayments, perhaps of 30 years, or a reduction in the value of the debt, the burden will become unmanageable, the IMF has argued. But even if European creditors meet the IMF demand, there could be a residual financing need in excess of what the IMF is comfortable providing. While the agreement in principle calls on the Europeans to meet any financing shortage, the risk in having the IMF go after the debt relief deal is that it becomes the de facto lender of last resort. In sum, Sunday’s election eliminates one set of risks facing the Greek effort to return to growth in the eurozone.  Harder tests remain.