Can the Eurozone ‘Kick the Can Down the Road’ Again?

Kick the Can

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Mauro Guillen and Sebastian Mallaby on the Greek Referndum

The “No” vote by the Greek public in Sunday’s referendum left little doubt that it was united behind the government’s stance – at least for now — on rejecting the latest position of eurozone and IMF creditors in the protracted negotiations over Greek debt. Very much in doubt, however, is how the fallout from the vote will play out. Wharton management professor Mauro Guillen thinks the chances of a Grexit are “greater than they were a day ago, three months ago, a year ago,” but that in the end, both sides will back away from the precipice because each has so much to lose. “Most likely, they will find a compromise solution Twitter  … and kick the can down the road to buy some time in hopes that the political situation in Greece might change.” [Editor’s note: European leaders have given Greece until July 12 to reach an agreement.]

Guillen’s comments came during a broadcast on July 6 on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.) Joining him on the show was Sebastian Mallaby, a senior fellow for international economics at the Council of Foreign Relations. Mallaby pointed out that much depends on how the European Central Bank (ECB) acts over the next few days and weeks on valuing Greek bank holdings as collateral for possible Greek loan restructuring. Since much of the collateral sitting in Greek banks is Greek sovereign debt paper, the ECB could rule that it is essentially worthless, and use that as the reason for denying loan restructuring. Whichever way the ECB goes, it will likely be a political decision more than an economic or financial one, based on pressure applied by the northern ECB country members, Mallaby notes.

An edited transcript appears below.

Knowledge@Wharton: What is the next step in Greece? Not a lot has touched on corruption within the Greek government.

Mauro Guillen: There are well-documented reports over the last five years about the excesses. [They also cover] the inability of the Greek government to collect taxes. Greece is becoming very quickly an example of a failed state. Not to the same extent as Somalia or Iraq, but it is a failed state. A government that doesn’t collect taxes. A government that cannot make things happen for its citizens.

Unfortunately, this populist government that came into office in January has made matters worse. This is a major problem. This is why the Europeans don’t trust the Greeks any more.

Knowledge@Wharton: Sebastian, what’s the main thing that needs to be changed now to try and at least start to turn the corner for Greece?

Sebastian Mallaby: It might be almost too late for that, because trust has been eroded so completely. The Greek leadership since the election in January has twisted and turned. [It] said it wanted to negotiate, and then accused its negotiating partners of blackmail. The Greek media has portrayed the Germans as Nazis. There’s so much ill will, and so low credibility, that even if [Alexis] Tsipras, the [Greek] prime minister, said he wants to accept XYZ terms, and promised the following reforms tomorrow, I don’t think anybody in the creditor group would believe him.

Knowledge@Wharton: Mr. Tsipras was quoted as saying that he believes it will be easier now to get a deal done than it was last week. Do you believe that?

Mallaby: He’s kidding himself … for the following reason. He seems to believe that the binding constraint on concessions from Germany and the creditors was some perception that he didn’t have democratic legitimacy within Greece. Now that that’s been reinforced by this referendum, which he won handily, [he believes] that now people will talk to him.

That was completely wrong in the first place. The problem was not Greek politics and the perception of his democratic mandate. The problem was German politics, and the fact that nobody in Germany wants to give money to a government that they perceive as wasting it. That’s the problem where [German chancellor] Angela Merkel won’t go further in cutting the Greeks a better deal.

Knowledge@Wharton: Mauro, did the vote surprise you? What does it really mean?

Guillen: This was mostly for internal consumption. The [Greek] prime minister was losing control over his own party, and wanted to get popular support for his approach to the negotiations. It also sends a very powerful signal to the rest of Europe that this government is not willing to live up to its responsibilities and to negotiate in good faith. Rather, it wants to turn everything into a referendum, and to frame every issue in terms of Greek’s national honor.

“This is not about honor. This is about debt. It’s about finding a solution to a very difficult situation.”  –Mauro Guillen

This is not about honor. This is about debt. It’s about finding a solution to a very difficult situation. Twitter  Having said all of that, I’d hope that at some point, we’ll also talk about Germany, and whether the Germans are doing everything they should be doing. It is absolutely fair to criticize Greece. But there are also a few issues with the position that the Germans have adopted over this crisis.

Knowledge@Wharton: Some of this does fall on the countries in the euro zone, in terms of their approach and how they view this problem, Mauro.

Guillen: No, absolutely. The issue is that they (other euro zone countries) don’t want to set a precedent. They don’t want to let the Greeks take the money without engaging in structural reforms. But at the same time, we have to remember that Greece has been going through a recession for the last five-and-a-half years. [Greece’s] economy has shrunk by 25%. Unemployment remains very high. There’s no light at the end of the tunnel.

The issue is that when you have so many countries in Europe that are tightly integrated in terms of trade — because their most important trading partners are other members of the same block — you cannot have everyone engaged in austerity policy simultaneously.

What I’ve been advocating for, but the Germans don’t want to do it, is for the surplus economies like Germany, Holland (the Netherlands), and others to raise their wages so that workers have more money to spend, and also, to avoid balancing their own budgets.

If everybody engages in austerity at the same time, where is the demand going to come from? We need demand in the economy in order for it to grow.

Knowledge@Wharton: Sebastian, what’s the next step in this process? The European countries have said, “We can’t go down this path again.”

Mallaby: There are three or four things happening simultaneously. The first is that the Greek government says it wants to carry on negotiating. Presumably, it will come out with some statement about how [it visualizes] the next step. That’s the political initiative from Greece.

The second is from the European creditor leaders who have to figure out what their next step is [and] what they expect from Greece. Then in parallel, you have the European Central Bank, which is almost a key actor right now. That’s what is propping up the Greek banks, to the extent that they are propped up at all. [It] is a line of credit from the central bank system, [which is] controlled ultimately in Frankfurt by the European Central Bank. [It is] to put cash into Greek banks so that people can go to ATMs and take out at least a little bit of cash to be able to carry on living.

The European Central Bank is under quite a lot of pressure to say that [it] can’t extend any more money, because the Greek banks are bust [and] so they’re not good for the additional loans. If the European Central Bank were to pull the plug, that would precipitate a complete meltdown. The Greek banks would be totally unable to open and provide cash to anyone. Then you would have a barter economy in Greece, and quickly, even worse political instability than you’ve already got.

Knowledge@Wharton: Between the ECB and the International Monetary Fund (IMF), Greece owes about 10 billion Euros over the next three months. If the ECB does say it can’t lend Greece any more money, that wouldn’t be surprising.

Mallaby: In order to provide liquidity to a bank, the central bank normally needs to see first of all that the bank it is lending to is not insolvent. Greek banks pretty much are insolvent, because they can’t collect their debts [from] domestic borrowers, [and that is] because the economy is in such a state that nobody can repay. That is point one.

Point two is that when you’re the central bank and you advance money to a bank, normally you require collateral. The collateral in this case is Greek sovereign debt, which the Greek banks own. They give that to the ECB to show that they are good for the loan. The problem is that Greek sovereign debt paper is not worth much, because the government is going to default.

Knowledge@Wharton: We keep hearing about whether or not Greece will leave the euro zone. Is that growing as a possibility, Sebastian?

Mallaby: It is growing as a possibility. All the logic of the situation points towards that. You’ve got the Europeans, who are pretty dug in on their position. The Greeks have lost credibility and can’t really persuade anyone that they are serious about reform and deserve further financing.

It’s a bit like a couple in a marriage where outsiders might observe that there’s so little trust that probably a separation is going to happen, but neither side in the relationship quite wants to recognize that yet. They don’t want to be the one to push the button and actually move out of the joint house. That’s where we are.

The reality of a Greek exit is going to be horrible for Greece and geopolitically problematic for Europe, because you’ll have potentially a failed state within NATO, and a failed state potentially staying within the European Union, even if it’s not the euro zone. I’m sure that creative politicians would like to find a way out. But when you analyze it logically as the third party, it’s not easy to see what that way out could be at this point.

Knowledge@Wharton: Mauro, is a Greek exit possible?

Guillen: Yes. It is more likely [now] than [it was] last week. It’s more likely than [it was] three months ago. It’s more likely than [it was] a year ago. I wouldn’t say it’s 100% likely, but it is far more likely. The issue here is, how far are the rest of the Europeans willing to go? I guess everyone continues to prefer Greece to stay. The problem when you found a monetary union is that if one member exits under these conditions, then it’s no longer a monetary union. Then it’s something [where] countries can become members but then also cease to be members. It becomes more like a fixed exchange rate system.

That’s not what the Europeans want. The Europeans want to convey to the rest of the world that this is for good; that it’s irreversible. That’s why the Greeks have some bargaining power in this situation, because they know that everybody in Europe would prefer them to stay.

The most likely outcome is that they will find some compromise solution, which will amount to essentially kicking the can down the road. [They would probably] buy some time, hoping that the political situation in Greece might change. But the critical point here is, what is the European Central Bank going to do about the banks in Greece? They need to support them, because otherwise the entire financial system in Greece, along with the economy, would collapse no matter what the IMF or the European Union does.

Knowledge@Wharton: The fact that the banks in Greece had to shut down last week would be a call to the citizens of Greece that this government is making some mistakes that need to be corrected immediately. Usually, when you have the banks shutting down and the citizens being only able to get a small amount of money at a time, one would have expected much more of an uproar against the government. It doesn’t seem like that has happened.

“It’s a bit like a couple in a marriage where outsiders might observe that there’s so little trust that probably a separation is going to happen, but neither side in the relationship quite wants to recognize that yet.”  –Sebastian Mallaby

Guillen: You’re absolutely correct. There is enough of [that uproar, with] at least 30% or 40% of the Greek population opposed to what the government seems to want to do in this crisis. But there are a lot of sentiments going on. There’s a lot of feelings. There’s a lot of non-economic considerations that people are using to justify their actions. Like, for example, voting no on this referendum.

People are approaching the final stage of desperation in Greece. This is very dangerous. It’s not just that the state itself is about to fail. But also, the population has realized at the last second that they have very little to lose. This is not good. This is a really bad situation, because when people feel that they don’t have anything to lose, they can be very irrational.

Knowledge@Wharton: But you believe the European leaders don’t want to see Greece leave the euro zone.

Guillen: Absolutely not, no. This has been repeated many times by different leaders. Not just Germany and France, but also Spain, Portugal [and] Italy. The governments in the other European capitals want Greece to stay. It will be a major setback for the European project if one of the members of the euro zone were to leave.

Mallaby: It may be a bit more complicated than that. In Germany, at least, there is a sense that you might want to make an example of Greece. If Greece crashes out of the euro zone, endures really appalling economic hardship, possibly has a military coup, goes through a really terrible time, [it] will send a message to the Italians and so forth that if they don’t get their house in order, they will be allowed to fall off the precipice and it will be very, very painful.

Germans believe in rules and discipline. When [Germany’s] finance minister [Wolfgang] Schauble said a few days ago that it might strengthen the euro zone to see Greece fall out of it, you know that’s what he’s thinking.

There is a very good counterargument Mauro has been making, which is that you don’t want to have a failed state within the European Union. I think the Germans are torn on this. Angela Merkel, the German chancellor, who has dealt a lot with [Russian president Vladimir] Putin over Ukraine and fully recognizes the geopolitical stakes here, can’t be happy with the idea of a desperate Greece that will probably turn to Russia and China for support if it cannot get it from the West. She, I’m sure, sees the political stakes and would like to keep Greece in.

But there is a strand of thinking there amongst the creditors that says, “No, Greece should never have joined. Keeping them in [involves] too much compromising of our principles. Every time we compromise [on] our principles, we encourage populist parties in Spain, Italy, Ireland and so forth to demand unrealistic things. Maybe economically and financially, we would be better off and stronger and more cohesive if we let the Greeks go out.”

Knowledge@Wharton: Mauro, you hinted at this. Do you see a growing possibility of violence in Greece? Also, when do you think is that showdown point?

Guillen: We’re approaching that point. I don’t know whether it will come in the end or not. But we are approaching a point at which the usual situation in which people go to work and try to do whatever they can to improve their lot, just doesn’t happen anymore. [That would be] because they’ve lost faith in the government, faith in the policies [and], faith in whatever they see as the minimum motivations to carry on. That is a distinct danger.

I don’t think we are near that moment. But we’re certainly much closer [to it] than, again, a month ago, or a few months ago, or six months ago. We need to remind ourselves that the Greek economy has been going through a terrible recession for five years. That’s a very long time. And that it has shrunk by about 25% in size.

This is a very difficult situation — one in which not just Greeks, but [also] Americans or Germans would react in a similar way. Five years or six years of a recession with no end in sight? That’s a serious situation. I don’t think there’s anything culturally different about the Greeks, when it comes to this. They are approaching desperation because the situation is really tough. [It is] very, very difficult for them.

Having said that, they are also a real part of the problem. It’s not just something that has happened to them and they have nothing to do with it. They need to change their ways. But people from many other countries would react in a similar fashion.



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