Greece and Creditors Head for the Brink

Hardened positions mean the scope for compromise looks vanishingly small

By SIMON NIXON

June 7, 2015 5:27 p.m. ET

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No one can be sure how the Greek drama will end, not least because it is no longer clear who, if anyone, is in control. Both sides have been bombarded for months by well-meaning advice to show flexibility and compromise to avoid an economic calamity in Greece and a geopolitical disaster for the eurozone and the world. Instead, positions have hardened to the point where the scope for compromise now looks vanishingly small.

Last week, Greece’s creditors offered what was effectively a take-it-or-leave-it deal to unlock Greece’s bailout cash before the program expires at the end of the month. Some eurozone officials had been hopeful that Prime Minister Alexis Tsipras would use a speech in the Greek Parliament to signal his willingness to accept the terms on offer. Instead, he called the proposal absurd and vowed to reject many of its key demands.

The creditors had clearly underestimated the scale of opposition to the proposals within Mr. Tsipras’s Syriza party and overestimated his willingness or ability to confront the party’s left wing. For his part, Mr. Tsipras appears to have overestimated how much flexibility he could expect from a process involving three independent, rules-based institutions with different mandates acting on behalf of 17 sovereign governments, each with its own political agenda. He called last week’s creditor proposal an “unpleasant surprise”—though the terms were broadly the same ones that the creditors have been demanding since June 2014, when the current bailout review began.

The dispute is partly one of substance. The creditors, led by the International Monetary Fund, insist that deep reforms to pensions and the public sector are essential to rectify deep structural problems built up during the boom years when Athens chased easy growth by raising pensions and civil-service wages to unaffordable, near-German levels.

If Greece still had its own currency, it could simply inflate away this problem. But since it is a member of a currency union—and wishes to remain in one—the only way to bring pensions and salaries back to sustainable levels is to pursue a so-called internal devaluation.

Yet creditors argue that successive Greek governments opted for the low-hanging fruit of tax hikes rather than implementing difficult overhauls of the civil service and pensions. These taxes fell on a narrow base—the value-added-tax system, for example, comprises at least six different rates and multiple exemptions—unsurprisingly leading to high levels of public resistance. At the same time, governments used the unreformed pension system to compensate for the lack of a modern social-security system, transferring many redundant civil servants into early retirement. That not only left large parts of the civil service with serious capacity shortages but did little to alleviate the burden on the public finances.

For the creditors, reforms designed to broaden the tax base and put the pension system back on a sustainable footing are essential to Greece’s long-term recovery—and the current crisis may be the last, best chance to achieve this. After all, if Athens can’t be persuaded to take tough decisions now, when will it ever?

Without these changes, the burden of restoring sustainability to the public finances will continue to be borne by excessive taxes on a weary population already in revolt and will continue to discourage investment and weigh on growth, which in turn will make it harder to pay down debt.

But Athens sees things very differently: It argues that reforms to pensions and salaries required by the IMF would be recessionary, since cuts to payouts would reduce domestic demand. It argues that the only way to revive Greece’s economy is via policies to boost demand through lower budget targets and a European Union-funded investment program, even if this means Athens will need to borrow more in the short term.

The disputes over substance might be bridgeable if the two sides could reach an agreement over debt relief, since the long-term degree of austerity required depends on the overall debt burden. Here the issue is primarily one of sequencing. No one doubts that Greece’s debts will need to be restructured again. The difference is that Athens wants this to be settled alongside the reform commitments, arguing that this is the only way to create the political and economic space for the government to act; the creditors argue that the reforms must come first, partly reflecting a lack of trust in Athens but also reflecting the political and legal obstacles to the eurozone making specific commitments to debt relief in the absence of a technical agreement on Greece’s budget and reform plans.

How this situation unfolds may now hinge on the IMF. The Washington-based institution has made clear that it intends to stick to its rule that prohibits it from lending to any country unless it considers there is a high probability that the debt is sustainable.

In recent weeks, it has been heavily criticized for its intransigence: by Athens for its continued insistence on tough reforms; and by the European Commission, which thinks its insistence on a clear eurozone commitment to debt restructuring is politically unrealistic and would prefer the IMF to fudge its debt-sustainability analysis to lower the bar for Athens to receive its bailout funds, thereby allowing the eurozone to kick the question of Greece’s debt burden down the road to the summer, when a new bailout will be discussed.

Last week, the IMF appeared to buckle under pressure, signing off on the deal presented to Mr. Tsipras even though it contained no promise of future debt relief. Managing Director Christine Lagarde later appeared to harden her stance, perhaps reflecting concerns from both emerging-market members of the IMF board and IMF staff.

The stakes couldn’t be higher: If Greece ends up leaving the eurozone, the IMF will find itself sitting on a giant loss, which would devastate its credibility as the world’s safest lender. On the other hand, if its brinkmanship yields a deal that forces Greece to implement far-reaching reforms and secures a eurozone commitment to future debt restructuring, it may yet do Greece—and Europe—a favor.

Write to Simon Nixon at simon.nixon@wsj.com