Why Europe Will Cave to Greece

45 JAN 28, 2015 1:00 AM EST

By Clive Crook

Bloomberg

A prediction for you: Greece and the European Union will split the difference in their quarrel over debt relief. What's uncertain is how their respective governments will justify the new deal, and how much damage they'll inflict on each other before accepting the inevitable.

EU governments, with Germany in the lead, are saying that debt writedowns are out of the question. Debts are debts. Greece's newly elected leader, Alexis Tsipras, calls the current settlement "fiscal waterboarding" and says his country faces a humanitarian crisis. His government won't pay and wants much of the debt written off. Neither side is willing to give way. 

What surprises me is that this all-or-nothing positioning takes anybody in.

Debts are debts? Please. Europe's governments have already provided debt relief to Greece. (In that process, private creditors saw their loans written down; most of what remains is owed to governments.) However, the plan hasn't worked. Greece's fiscal position was so bad that the haircuts, reschedulings and interest-rate concessions weren't sufficient to restore its creditworthiness. At the same time, thanks to slower-than-expected growth, the fiscal conditions tied to the settlement proved harsher than intended. Greek voters have just repudiated those terms.

In other words, the existing settlement has failed. It therefore needs to be revised. No conceptual revolution is required. This conclusion follows from the same kind of analysis that EU governments have already relied on.

For sure, granting additional debt relief has drawbacks -- just as there were drawbacks to granting debt relief in the first place. It sends a bad message; it encourages bad behavior in future; it will inflame resentment among voters in other EU countries. That's why it's a good idea, so far as possible, to make relief conditional on efforts to behave responsibly. But the likely consequences of any EU refusal to budge are much worse.

There's a serious risk that Greece will default unilaterally. This would not be in Greece's interests, but it's too close a call for comfort. The existing settlement will require the government to run primary budget surpluses (that is, excluding interest payments) in the neighborhood of 4 percent of gross domestic product. That means that if Greece defaulted, it could cut taxes or raise public spending substantially without needing to borrow.

The downside of default would be huge -- possible ejection from the euro system. That would be a calamity for Greece and, because of the risk of contagion, for the rest of the euro area as well. Nonetheless, if the EU offers Tsipras nothing, that's how things could turn out.

Therefore, in the end, the EU won't offer nothing. But the posturing on both sides needs to stop and discussions of a possible compromise need to start quickly, or Tsipras and the EU could talk themselves into the worst-case scenario they both want to avoid.

Outright debt forgiveness would be hard for Europe's leaders to sell to their own voters; like Tsipras, they've boxed themselves in. However, they can provide debt relief in many other ways.  "Extend and pretend," as it's called, is relief by another name. Maturities could be stretched further. Debt-service costs could be cut again with concessionary interest rates, perhaps including a moratorium on payments. The creditors could tie debt service to Greece's growth rate -- the stronger its economy, the more it pays. Tsipras has already broached this last possibility.

The EU should also agree to modify Greece's supervised austerity program. Some of the projected primary surplus should be given back to Greek voters in the form of social spending.

Now that Tsipras has won his election, he needs to be less of a populist demagogue and more of a pragmatic leader. He should recognize the need for further structural economic reforms, and offer commitments in exchange for debt relief. As Reza Moghadam, former head of the International Monetary Fund's Europe department, notes in a column for the Financial Times, Syriza is an anti-establishment party. Despite its hard-left policy platform, it could be more open than its predecessors to breaking the grip of entrenched interests. Its election success can't be undone in any event. It's an opportunity worth exploring.

Does Greece deserve this new dispensation? It's a fair question, but there's no straightforward answer and it's largely beside the point. A new compromise on Greek debt is the best feasible outcome not just for Greece but also, in view of the risks, for Germany and the other EU countries. They just need to get on with it.  

To contact the author on this story:

Clive Crook at ccrook5@bloomberg.net

To contact the editor on this story:

James Gibney at jgibney5@bloomberg.net