Alexis Tsipras and his Eurozone creditors looked over the cliff and into the abyss and did not like what they saw. Taking a step back, they agreed – in principle – on yet another (third) bailout package for Greece.
With details still to be determined and only if ultimately agreed on, this programme will provide sufficient funding for Greece to repay outstanding debts to the IMF, avoid further defaults to official creditors in the near future, and provide additional fiscal space for the Greek government. If things move along over the next few weeks according to plan, the ECB will increase liquidity support to the Greek banks, which will allow them to reopen. And while debt to GDP will rise even further to 200% of GDP, the structural reforms agreed upon might have the potential to make growth pick up again.
As so many times before, the outcome was a political compromise, with no winners and several potential losers on both sides. The important question is whether this political compromise makes economic sense and whether this will be the bailout to end all bailouts. As much as I would like to give positive answers to both, I believe that the answer is “no”. More important, however, is that there is still a chance to use the momentum to expand on this short-term compromise for a long-term, more sustainable solution, both for Greece and the Eurozone.
Why it might work
The new agreement is internally consistent, in the sense that it seemingly avoids some mistakes of the previous two programmes, at least in the view of the creditors. Rather than trusting that the Greek government will implement the necessary structural reforms, these reforms are now a pre-condition. Rather than taking a step back from steering the reform process in Athens, the Troika will get even more involved in legislative drafting to avoid previous incidents where agreed legislation was changed last minute due to internal pressure by special interests in Athens. Rather than trusting the Greek government to privatise state-owned assets, the creditors will force its hand by having assets transferred into an independent trust fund. And the creditors will try to make the agreement as election-proof as possible to avoid future backtracking.
Having suffered from closed banks for two weeks and the perspective of capital controls for many months to come will focus the minds of current and future Greek governments and might force them to implement the necessary reforms. Pushing through structural and institutional reforms rapidly prevents special interest groups from organising themselves quickly enough to fight against these reforms and defend their privileges and rents.
It is thus clear that the agreement addresses political constraints by creditor countries who have to fight critics at home who argue that yet another bailout implies throwing more good money after bad. And there is just a little bit to also address Greek political constraints – the promise of possible future debt reduction and additional investment funds from various EU programmes.
Why it probably won't work
There are many reasons, however, to be rather pessimistic about this agreement. First, the immediate reaction of the Greek government clearly indicates that the reforms outlined in the agreement are not their reforms, but perceived as being imposed from outside. These reforms are clearly not ‘owned’ by the Greek government or – so it seems – a large part of the political elite in Athens. Critically, there is no time to create ownership for these reforms, given that they have to be passed by Parliament within a few days – to be consistent with the political constraints described above. Ample experience, however, has shown that reform programmes not owned by a country’s government typically do not work, as emphasised by the head of the Eurogroup Jeroen Dijsselbloem himself after the break-off of negotiations in late June.
Second, as much as the new programme might satisfy the political constraints in the creditor countries, it might lead to further socio-political instability and turmoil in Greece, which ultimately makes the implementation of the much clamoured reforms difficult if not impossible, and will further delay economic recovery. Parts of the agreement are seen as a violation of national sovereignty, which risks even more of a nationalistic backlash.
Third, as banks reopen, while capital controls will most likely stay in place, it remains to be seen over the next six months how much damage has been done to the Greek banking system and the Greek economy. Some of the underlying economic assumptions about fiscal needs and GDP might therefore have to be reassessed, which ultimately might lead to further stand-offs between Greece and the creditors.
Fourth, as with previous programmes, the commitment to run primary surpluses in the near future is not time-consistent as there is always the threat of renegotiation. In 2014, when the fiscal position of Greece was close to returning to a primary surplus, the Greek government started to backtrack on promised reforms. A similar scenario looms in the future. This will therefore certainly not be the last stand-off between the Greek government and its creditors. Ultimately, the question of a debt cut has to be put on the table, as much for economic as for political reasons.
Ultimately, it comes down to credibility. As much as trust (or the lack thereof) was the theme over the last weekend (mostly lack of trust by the Eurozone creditor vis-à-vis the Greek government), credibility that this agreement will make the threat of Grexit go away is critical for economic recovery and growth in Greece.
What is needed to make it work better
Using the Grexit option was seen as a smart negotiation strategy by the Eurozone creditors vis-à-vis Greece (with Ms. Merkel and Mr. Schäuble described as a ‘good cop, bad cop’ team). However, leaving the Grexit threat on the table or even institutionalising it as a threat against fiscally misbehaving governments will undermine the stability of the Eurozone permanently. As long as there is the threat of Greece exiting the Eurozone, the necessary certainty for long-term investment in the Greek economy is missing.
The fact that the banking system was at the core of the stand-off illustrates this problem. The risk of Grexit serves as a trigger for Greek depositors to run on their banks at the first sign of trouble, to thus avoid redenomination risk. This can turn into a vicious cycle, as we have just observed – a fiscally profligate government, or simply political instability, would result in negative expectations leading to deposit outflows, undermining the banking system and ultimately the real economy, which in turn makes the fiscal position even less sustainable, leading to more uncertainty and outflows, and so on. Without a fully functioning banking system, a modern market-based economy cannot function, ultimately pushing Greece back into recession if not outright economic meltdown. In this sense, the banking system currently serves as a transmission channel for crises of confidence rather than as a support sector for the real economy.
The banking union established last year was supposed to cut the link between sovereign and bank fragility. In the case of Greece this has clearly not worked. The only way to cut this vicious cycle is to (i) separate the banks completely from the government, and (ii) thus make a Grexit or Graccident impossible. In the specific case of Greece, this would imply turning the banking system into a foreign-owned banking system, supervised completely by the ECB, which treats the Greek government as any other client, i.e. with no privilege, especially in lending or bond holdings. At the Eurozone level, this implies completing the banking union (i.e. completing the bank resolution component and introducing a common deposit insurance fund). This might still leave future Greek or other Eurozone governments without access to market funding or even in default, but at least it would not ‘allow’ them to pull banking systems and whole economies down with them. Ultimately, the objective is to get to a situation as in Puerto Rico – as sad as the fiscal situation is there and as negative its repercussions are for Puerto Rican residents, there is no spillover to the banks in Puerto Rico nor any risk of Puerto Rico leaving the dollar zone. As additional institutional reform, a sovereign insolvency framework is urgently needed.
The compromise this Monday morning was a political one and might well have prevented worse outcomes. However, it runs the risk of increasing political tensions further. It has not solved the underlying problem of a continuing risk of Grexit. Having jointly decided against Grexit as part of the compromise, it is critical that the Eurozone authorities ensure that such risk will be eliminated as soon as possible. Important institutional changes have to be made for that.
This stand-off between Greece and its creditors will most likely not be the last one. As the can of Greek sovereign debt keeps rolling down the road, the least that the Eurozone should do is rid it of the additional weight imposed by the risk of Grexit and the deadly bank-sovereign embrace.