Greece, The EU And The IMF Are Dancing With Death

MAY 25, 2015 @ 11:50 PM

By Frances Copolla , contributor

The Forbes

Over the last few months, the world has been watching with interest and growing concern the intricate moves in the deadly dance of Greece, the EU and the IMF. The latest move in the dance comes from Greece itself. The Interior Minister has announced that Greece cannot meet scheduled debt repayments to the IMF in June.

This does not mean that Greece intends not to pay. Rather, it is warning that intransigence by the EU may force it into an IMF default.

It is not the first time Greece has used the “IMF default” tactic. At the beginning of May, Greece said it couldn’t pay an IMF loan repayment. Then, in a surprising move, it drained its SDR reserve account at the IMF to make the payment. This is effectively a short-term loan at a low interest rate from the IMF to Greece. And it is Ponzi finance – lending to a borrower so that he can service existing debts to the same lender. Using the SDR account solved Greece’s immediate cash shortfall, buying time for further negotiations. But it stores up further problems in the future. The SDR account will have to be topped up at some point.

Interestingly, the IMF appears to have advised Greece to use the SDR account for the payment. And this makes me wonder what strategy the IMF is playing. It seems to have decided to cooperate with Greece.

Superficially, the IMF’s aim is to recover the money it has already lent to Greece. But it has another, much larger concern. The Greek crisis is threatening the IMF’s own credibility.

The IMF’s involvement in the Greek bailout was controversial from the start. It broke its own rules in order to lend to Greece in 2010, arguing that systemic risks justified lending to a country whose debt was not by any stretch of the imagination sustainable over the medium-term. It was severely criticized by members of its own board of directors, notably by emerging-market representatives who were understandably miffed at what appeared to be special treatment accorded to Greece, or more accurately, to the Eurozone’s banks. The Brazilian representative, Paulo Nogueiro Batista, observed that the program:

“…may be seen not as a rescue of Greece, which will have to undergo a wrenching adjustment, but as a bailout of Greece’s private debtholders, mainly European financial institutions…”

And the Swiss representative tellingly asked why debt restructuring with losses for creditors was not on the table.

Two years later, debt restructuring was on the table. And there it remains.

The 2012 “private sector involvement” (PSI) restructuring wrote down up to 80% of the net present value of Greece’s private sector debts. But much of the debt had already been transferred to the public sector, not only as a result of the 2010 bailout but also through subsequent IMF and EU loans and ECB support of Greece’s banks. The PSI restructuring reduced Greece’s debt to just over 150% of its GDP. Everyone knew that this was inadequate. Everyone knew that the official sector would have to suffer a haircut as well, and the longer it was delayed, the more costly it would be. But the EU governments and institutions did not wish to accept a haircut, and the IMF didn’t want to force them to. So they played “extend and pretend”.

A Memorandum of Understanding was prepared, underpinned by a detailed IMF program. The structural “reforms” agreed between the EU, the IMF and the then Greek government were supposed to reduce Greece’s debt/GDP to 120% of GDP by 2020. Although this forecast was founded on hilariously unrealistic assumptions regarding growth, inflation and tax revenues, it was dubbed “sustainable”. On that basis – and despite further objections from emerging-market representatives — the IMF contributed new funds to the Greek bailout program.

The continuing depression in Greece has caused the debt burden to increase, not because nominal debt has increased much (Greece has managed to bring its budget into primary balance, more-or-less) but because GDP has collapsed. Debt is now around 175% of GDP and probably rising, which is where it was when the PSI was agreed. Greek debt is unsustainable. Everyone knows it is. The only question is when, and how, it will be restructured.

So the IMF is now in a difficult position. It cannot lend more to Greece, because to do so would be to admit that the EU’s measures to eliminate systemic risk have failed. But it can’t call for debt restructuring and relaxation of budget targets without raising the possibility that it may have to take a haircut itself. And the board members who originally opposed the deal are now vociferously saying “we told you so”.

Given all of this, the IMF’s best strategy is a fast exit. And that seems to be what it is aiming for. Christine Lagarde’s pointed insistence that the IMF program would end in March 2016 should be seen in this light. The Fund wants out – with its money.

The Fund’s strategy is oddly compatible with Greece’s. Jacques Sapir, in a blogpost back in February that blew my mind, explained that Greece was adopting a “strength through weakness” approach:

“…In this strategic game, it is clear that Greece has deliberately chosen the strategy qualified by Thomas Schelling, one of the founders of game theory, but also of nuclear dissuasion, as “coercive deficiency”. In fact, this term of “coercive deficiency” was imagined by L. Wilmerding in 1943 in order to describe a situation where agencies enter into expenses without prior financing, knowing that morally the government will not be able to refuse funding them…. it can be rational for an actor knowing himself to be in a position of weakness from the start, to increase his weakness in order to use it in negotiation. …… putting Greece voluntarily at the edge of the abyss and demonstrates all at once its resolve to go the bitter end (like Cortez burning his ships before moving up to Mexico) and to increase the pressure on Germany. We are here in a full blown exercise of “coercive deficiency”.

Greece stands as close as possible to the cliff edge and dares the other players to push it over, knowing that it is not in their interests to do so. It has played this hand extraordinarily well so far, managing to avoid a catastrophic default while steadfastly refusing to cooperate with the EU or – until now – the IMF.

But the IMF has now joined Greece on the cliff edge. The challenge to the EU has changed from Greece’s “Go on, push me” to “Sort this out or we’ll let go” from the IMF.

The ECB must be spitting blood. It has been trying the same strategy for months – hence the “asphyxiation” of Greek banks about which Greek finance minister Yanis Varoufakis complains. But the ECB has too much to lose. If Greece falls over the edge, there is a serious risk that it will take the Euro down with it – and that means the end for the ECB. The IMF can credibly play this strategy. The ECB cannot.

he European Commission’s position is equally difficult. For the present incumbents, allowing Greece to default and leave the Euro would threaten their own positions. It would, at the very least, be a mammoth policy failure, even if it didn’t fracture the Euro beyond repair. And default within the Euro is debt restructuring, which so far they aren’t prepared even to discuss. But they don’t want to give in to Greece’s demands, because that would undermine the austerity-based “fiscal compact” they have so carefully constructed. So they are happy to let Greece dangle, but they don’t want to see it fall. The IMF’s brinkmanship is therefore very worrying for them.

On the other hand, some European government leaders, notably the German finance minister Wolfgang Schaueble and his Austrian counterpart Hans Joerg Schelling, seem to be happy to allow Greece to fall. Indeed, popular opinion in their countries would be pleased if they cut the rope. But disorderly default and exit for Greece would have unquantifiable effects: those in favor of it may say, with some bravado, that they have protected their banks so Greece presents no systemic risks, but they can’t prove this. If they allow Greece to fall, and the economic consequences for Europe are catastrophic as many predict, they will face punishment at the hands of their own electorate. In their own way, the opponents of Greek debt restructuring are also on the edge of the cliff.

The EU, therefore, is a house divided. So how will it respond, faced with the deadly cooperation of Greece and the IMF?

There are some indications that it is starting to lose its nerve. On 18th May the Greek newspaper To Vima reported (Greek) that the EC had offered Greece a deal which made important concessions, particularly on the primary surplus and the timing of tax rises. The deal also allowed the IMF a graceful exit. Predictably, the EC denied it had made any such offer. But it does appear that President Juncker has been working on a proposal that he hopes would be acceptable to all sides.

So how will this “death dance” end? Will Greece default? If it does, will it leave the Euro?

Leaving the Euro is in my view unlikely. Hardliners may be comfortable with Greece leaving the Euro – whether explicitly, or indirectly via a parallel currency – but no-one else wants that. Default, however, is a different matter. These negotiations are like a sword dance – precision is everything. If any of the participants makes a wrong move, default is certain. Furthermore, a run on the Euro is a possibility, particularly if the ECB pulls the plug on Greek banks.

The aim therefore is to achieve an agreed debt restructuring and establishment of a realistic reform program while enabling the IMF to get out and the EU to save face. So Greece will eventually get the debt restructuring that it wants, and some (though probably not all) of its economic demands, simply because the alternatives are worse. But getting to this point will test the nerves of the entire world: absolutely no-one wants to be seen to give in to Greece. And it will take the patience of a saint and the diplomatic skills of a Machiavelli. President Juncker seems to have taken this on. I wish him the very best of luck. He will need it.