Making Sense of the Options for Greece

 10, 2015

Political Economy

By HUGO DIXON | REUTERS

Greece seems to lack a strategy for extricating itself from its parlous state.

Not only does the government, led by Alexis Tsipras, lack a credible plan for reaching agreement with its eurozone creditors and the International Monetary Fund, it doesn’t seem to have a thought-out fallback plan of how to default while containing the damage.

Greek financial markets have perked up in the past few weeks, largely because Yanis Varoufakis, the combative finance minister, has been sidelined from discussions with the creditors.

The new composition of the negotiating team has led to more productive talks, but there is still a mountain to climb and little to no chance of a deal when eurozone finance ministers . meet on Monday

When Mr. Tsipras took office in January, he seemed to have thought he could extract more cash from his creditors as well as secure relief on Athens’s debts without undertaking serious reforms. This was pie in the sky.

The government also didn’t initially factor into its calculations how badly the economy would be damaged by months of political uncertainty and a liquidity crisis. In November, the European Commission was predicting growth of 2.9 percent this year. Last week, it cut that to 0.5 percent, and even that could prove optimistic.

The deteriorating economy means Athens will find it a lot harder to balance its books. Even if its creditors lower the budget target for this year, the government will have to introduce more austerity measures, and that will further damage the economy.

Athens’s cash position is desperate. It needs to repay the I.M.F. 750 million euros, or about $840 million, on Tuesday and give it a further €1.5 billion in June.

Mr. Tsipras hopes he can persuade his eurozone creditors to lend Greece some cash in the next few weeks to stave off bankruptcy. But that will only be possible if he crosses his own red lines on matters like pensions, labor laws and value-added taxes.

Even if Athens survives its immediate liquidity crunch, it will struggle to secure a long-term deal. Negotiations on that are scheduled to finish by the end of June, but they are not supposed to start until the talks on the short-term deal are concluded.

The problem is not merely a matter of time. It is also a matter of money. Given Greece’s deteriorating economy, the next bailout will require more than previously estimated — perhaps topping €50 billion. It will be hard to persuade other eurozone nations to cough up this sort of cash, not least because good will toward Greece has almost vanished.

Given such a gloomy prognosis, it is important to examine alternatives. There are two: default and leave the euro, or default and stay in the single currency.

The latter would be the least bad option, though far from good. To minimize the damage, the government would have to recapitalize the banks, as a default by the government would tip them into insolvency, too. If they weren’t recapitalized, the European Central Bank would cut off liquidity, the banks would go bust and the economy would be dragged further into the abyss.

The snag is that Athens would not itself have the cash to bail the banks out and wouldn’t be able to get any money from abroad either. The only solution would be to “bail in” depositors — converting a portion of their savings into new equity in the banks.

Although the banks are not very exposed to the government, they would also need to be recapitalized to take account of the fact that more loans to the private sector would turn sour.

If Athens defaulted, it would also have to live within its means. Although the government would no longer need to find cash to pay its creditors, it would still have to cut salaries and pensions because tax receipts would fall in line with the deteriorating economy.

Some pundits, including Martin Wolf, of The Financial Times, suggest that Athens should instead pay salaries and pensions by issuing i.o.u.s. This would be a bad idea because, whatever the government said, the Greek people would see these i.o.u.s as the precursor of new drachmas and would discount them heavily.

Tax revenue would plummet — partly because the economy would be shrinking and partly because citizens would be loath to pay taxes in euros if they thought the drachma was around the corner. So the government would have to issue yet more i.o.u.s, leading to a vicious circle in which quitting the euro might become a self-fulfilling prophecy.

But that’s not a good option either. Quite apart from the fact that the Greek people don’t want to leave the single currency, the transition to the drachma would be nightmarish. And even once the currency was reintroduced, there is little likelihood the government would run a responsible economic policy. It would probably print money, fueling a spiral of inflation and devaluation.

Given that even the best Plan B is dire, Mr. Tsipras should work out a realistic strategy for how he is going to come to terms with his creditors. And do so fast.

Hugo Dixon is editor at large of Reuters News.