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Europe Calls Greek Bluff, But the Greeks Aren’t Bluffing

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Negotiations between Greece and the Eurogroup were broken off late this afternoon due to a failure to “find common ground,” as Eurogroup Chairman Jeroen Djisselbloem said during a later press conference. The Eurogroup had insisted that there was not enough time to renegotiate the bailout conditions prior to the the end of the current program on the 28th of February. Only after accepting the existing conditions could discussions over new terms be discussed. The Greeks rejected this condition as “absurd”. Wolfgang Schaeuble, German Finance Minister, declared there would be no bailout extension, while a member of Angela Merkel’s CDU party, Hans Michelbach, called for all funding of Greece to be immediately stopped.

Greek Finance Minister Yanis Varoufakis, during his press conference, sounded much more conciliatory – but in reality, he was not. He threw out all the right soundbytes: both sides very close to agreement; the EU is unbreakable; the European democracy would support the popular mandate given to Syriza. But his most important comment was brutally direct and aimed straight at Frankfurt: “Greece will not be a debt colony.”

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There was a bit of mystery and drama as well; or perhaps it was just another example of EU bungling. At some point before the negotiations, French Finance Minister Pierre Moscovici showed Mr. Varoufakis a copy of a statement with the Greek Minister found acceptable. Apparently, that statement was withdrawn, probably after an infuriated “Nein” from Herr Schaeuble, who was not prepared to let the French flank the German position. The subsequent statement from the Eurogroup included the proviso requiring acceptance of the current program terms, and here we are.

That condition is absurd: the Greeks already rejected the current program when they voted overwhelmingly for Syriza and against what they considered the Troika stoolies of New Democracy. And support for Syriza remains high: approximately two thirds of Greeks support the government’s stance towards Europe, which is far higher than the percentage of Greeks who voted for the party in the elections.

The Eurogroup has declared that they have no more intention of moving unless Greece expresses its willingness to accept the prepared statement. They are counting on the Greek government preferring a slow death to a fast one. There is also an expectation that the Greeks will lose heart as the deadline approaches and debt markets fail to signal fear of a Grexit: but that too is absurd, since debt market pricing mechanisms have been broken since the ECB began their massive intervention in them. The lack of a signal is because the ECB does not wish for there to be one, not because there is no risk of contagion. The Greeks are not stupid and are not likely to be fooled by this rather obvious ploy.

Nevertheless, we appear to be in a classic prisoner’s dilemma: where two rational opponents may nonetheless pick the least optimal outcome. Although Mr. Varoufakis is a recognized expert in game theory, it is not clear that he can find a way out of the impasse despite his expertise. The Greeks seem terrifyingly confident that the EU understands that Greek default opens up a black hole of possibilities for Europe and the single currency. Meanwhile, the Germans seem determined not to be blackmailed by the Greeks, regardless of the costs. For the moment, the rest of the EU is backing them…but that may not last. The Portuguese have expressed support for a temporary extension of the current program to enable negotiations to be conducted: an extension of financing, not necessarily of the reforms. The IMF, despite being a principal architect of the hated Troika, has also urged the EU to “be flexible” in dealing with the Greeks. Given that the IMF is one of the primary holders of Greek debt, their opinion matters.

It is my opinion that nothing fundamentally has changed: the breaking off of negotiations is merely another step in the dance, a bluff. The EU has called the Greek government to see if they will fold. Ample time remains for agreement, because agreement at this time need not be permanent. Both sides need only back off from the brink, agree to a four month extension, and settle down to arrive at a face saving solution that also saves the euro. Gross miscalculations do occur however, with horrible consequences at times – such as Hitler misreading Allied resolve during the Polish crisis of 1939 which led to war. In this case, both sides may dig themselves in so deeply that not even a temporary agreement is possible before the expiration of financing on the 28th.

These would be uncharted waters indeed and it is worth speculating a bit on what might occur.

Beyond Scylla and Charybdis

If the Greek bailout program expires without anything existing to replace it, both the Greek government and the Greek financial system will come under immediate pressure. The Greek government has large liabilities that it must fund since it is running a large deficit; additionally, it will have to pay or roll-over approximately 1.5 billion euros in IMF loans. The government is unlikely to be able to both pay its creditors and finance itself for more than a month; perhaps not even that.

More immediately, the Greek financial system is liable to collapse. If the sovereign is cut-off from bond markets, private Greek banks certainly won’t be able to access them. Nor will they be able to access ECB funds; in fact, they are already denied access to ECB liquidity. The banking system is being kept alive through the Emergency Liquidity Assistance, which the ECB authorized at the same time as it cut off the Greek banks. The important difference is that the ELA funding goes on the Bank of Greece’s balance sheets rather than those of the European Central Bank. If no program extension is agreed to, it is highly likely that the ECB will order the suspension of the ELA, causing a liquidity crisis and the collapse of Greek banking.

Now it gets interesting:

1. The Bank of Greece refuses to suspend ELA. Legally, they cannot refuse…but since we are in uncharted waters we can ask the question. What if the Bank of Greece simply keeps printing euros to keep the banking system afloat? The ECB can hardly refuse to accept “Greek euros” without torpedoing the whole concept of the single currency. They could fine the Bank of Greece and seize any Greek assets currently held on their balance sheets, but the Greeks might be desperate enough not to care. This would be a major constitutional crisis for the EU, with a member state exercising its sovereign right to save its banking system come what may and in direct conflict with a major European institution;

2. The Greeks could simply default and let the chips fall. This is the ultimate “your move” gambit. If the Greeks default, but at the same time refuse to leave the Euro, what does the EU do? It doesn’t have the legal authority to kick any member state out of the Union or out of the single currency without that state’s consent. There is no law that says that the Greeks must revert to the drachma if they default; that is only an assumption of what might happen. Of course there would be chaos; but the Greeks might resort to desperate measures, like illegally printing more euros than they are authorized to issue, and there really isn’t anything the EU could legally do about it. Europe would face a constitutional crisis in this case as well, and might have to invent a mechanism to expel Greece.

3. The Greeks could issue “hellenikones”. The “hellenikones” would be the Greek equivalent of Argentina’s patacones: non-convertible government promissory notes, fiat money. The government of Buenos Aires introduced the bono patacon as a way of paying for government charges during the height of the 2001 convertibility crisis; the notes began to circulate as fiat currency with an unofficial exchange rate for dollars and pesos on the black market until the collapse of the currency board in 2002.

If Greece does resort to hellenikones or any other sort of fiat money, including bills on future tax receipts, it’s a clear sign that the gig is up. A drachma by any other name is still a drachma;

patacon

4. Greece could find an alternate source of short-term finance. The only realistic options are the Russians. There are other players that have deep enough pockets to fund the Greek government in the short-term, like China, Japan, the US or some of the Persian Gulf states. But none of them has shown any interest to do so; and while the US is intimately concerned with the success of Europe, it is inconceivable for the President to order or the Congress to authorize a bailout that goes against the wishes of the EU.

The Russians might indeed be willing to use some of their $380 billion reserve fund to keep Greece afloat; but they wouldn’t do it out of charity, nor out of sympathy for a fellow Orthodox country, and they certainly wouldn’t do it to keep the EU together. They would expect a very big quid pro quo such as Greek withdrawal from NATO and basing rights in Greece. Such a deal is inconceivable so long as Greece believes there is still a chance for it to stay in the EU. If all hope fades, however, anything is possible.

What remains clear (to everyone but Wolfgang Schäuble) is that the Greeks are right: the risks inherent in a failure to negotiate far outweigh the political costs of reaching a negotiated settlement. Austerity was supposed to be a remedy to Europe’s problems, but now maintaining the policy appears to be more important than preserving the single currency and the European Union itself. That is a topsy-turvy world Germany has entered. It remains for the rest of Europe to make the Germans see reason.

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