Making sense of the latest Greek drama

I love reading Zero Hedge. I read the website with the same guilty pleasure that I have when I peruse the tabloid headlines at the supermarket checkout line. Here is just a sample of ZH`s latest "news" on the Greek drama:

• Greece just blew up the Empire's Debt Star of Debt
• Europe fractures: France "prepared to support Greece" in debt negotiation
• ECB threatens Athens with bank funding cutoff if no deal in one month; February 28 is now D-Day for Greece
• Greece begins the great pivot towards Russia
• Tspiras does not rule out Russian aid as UK Chancellor calls Greece "Greatest risk to global economy"

Zero Hedge is useful in that their stories do have some element of truth, even though those elements are buried in the clickbait headlines, just as the headlines found in supermarket tabloids are designed to sell papers.

What each side wants

In order to cut through all of the noise, it`s useful to understand what each side wants. It seems that the new SYRIZA government in Greece have two main objectives:

• A rollback on some of the painful austerity measures imposed as part of previous rescue packages, now that Greece is running a primary surplus (a budget surplus before debt payment).
• Some form of debt relief.

The Troika (EU, ECB and IMF) have several objectives in mind:

• Structural reform see Mario Draghi reveals the Grand Plan)
• No forgiveness of the face value of the debt. The chart below shows what Greece owes and to whom. The IMF always get paid in full. The bulk of Greek debt is owed to other eurozone governments and it would be political suicide for a German, French, Dutch, etc. leader to tell their citizens that their taxes are going to support Greece. 

However, but there is room for changing the NPV of the debt. For example, if I owed you $1 million and couldn`t pay, a proposal of paying $1 a year for the next million years may be an acceptable starting point for negotiation. (If not, how about $10 a year for the next 100,000 years?)

Given what has been said in public, the two sides aren`t that far apart. The WSJ had a thoughtful article entitled "As Greece and EU Clash, Clues on Deal Emerge" that summarizes the situation perfectly:

European policy makers and advisers who have begun studying the nitty-gritty say compromises, while difficult, appear possible on the central issues. Those include how tight a budget Greece should run; whether to rejigger Athens’s debts to other eurozone governments; which broader overhauls Greece’s economy needs; and how creditors should supervise agreed-to policies.

“On the economics, there is room for compromise,” said a senior German official. “The question is the politics: What can Syriza live with, and what can get through parliaments in Germany, Finland and elsewhere?”

Publicly, Syriza has demanded a major restructuring of Greece’s bailout loans, but in private, Greek officials say they are hoping for a repetition of concessions Europe has previously made: extending loan maturities and trimming and postponing interest payments.

That would allow Greece to spend a little more and tax a little less than under previous plans, giving its depressed economy some oxygen. European officials say Syriza will still have to curtail some of its spending promises.

The “nuclear“ threat(s)

Each side also has a number of options to go nuclear in these negotiations. Greece can do the following:

• Default on its debts
• Exit from the euro and reinstate the Drachma
• Exit from the EU

The biggest bludgeon that the Troika has is the ECB`s threat of withdrawing funding from the Greek banking system. While the Greek government has not brandished any of their ultimate nuclear threats, the ECB has not taken this non-funding option off the table. A Reuters report quoted Erkki Liikanen, who is the Finnish representative on the ECB Governing Council, as saying that the ECB has rules and it can't change them at will for any member state (emphasis added):

"We (ECB) have our own legislation and we will act according to that... Now, Greece's programme extension will expire in the end of February so some kind of solution must be found, otherwise we can't continue lending," Liikanen, also the governor of Finland's central bank, told public broadcaster YLE.

"I don't believe that one can hide from the realities in the economy," he said in an interview.

The Russian pivot
A number of red herrings  have surfaced during these negotiations. The most notable has been a possible Greek pivot towards Russia.

Oh, please! Give me a break! That's as likely as Netanyahu embracing Hamas as the partner in an Israel-Palestine two-state permanent peace solution.

The Russians had their chance during the Cypriot crisis in 2012 and they passed on that opportunity (see my previous post Europe dodges another bullet (not the Catalan election)) and therefore it is highly unlikely that Russia will extend Greece loans today. Back in 2014, there were many good reasons for Russia to rescue Cyprus:

• There was lots of Russian money in Cypriot banks;
• Noble Energy had discovered a large gas field off the Cypriot coast;
• With a friendly Cypriot government, Russia could have neutralized some key NATO bases on the island; and
• It might have had an alternative naval base for the Russian fleet in addition to their port facilities in Syria.

We know what happened. Moscow passed on the opportunity.Now imagine what would happen if Russia tried to extend loans to Greece today. The Troika has already given Greece loans at below market rates and extended repayment terms, which reduces the NPV of those loans. Were Athens were to attempt a Russian pivot, those loans would move towards market rates virtually overnight. Is Putin ready to take on those kinds of obligations?

Russia has enough on its plate today without getting involved in Greece. With the Russian economy in shambles and Belarus threatening to leave the Eurasian Economic Union, ask yourself what Russia can do for Greece, aside from linking arms and singing a rousing chorus of Internationale?

Is it any surprise that Alexis Tsipras had the following response to a question about a possible Russian loan?

The Greek proposals

It seems that PM Tsipras and his finance minister Varoufakis are playing a game of good cop-bad cop during these negotiations. Varoufakis (bad cop) would make outrageous statements during the negotiations and Tsipars (good cop) would temper them with reasoned responses.

As I write these words, Varoufakis is making the rounds of European capitals in an attempt to split the EU. It is instructive to see that his first visits were to France (which is searching for ways to loosen the EU austerity spending straitjacket) and the UK (which is not part of the eurozone, but whose economy recovered faster than the Continent because of a combination of looser fiscal and monetary policy.)

At the same time, elements of the Greek proposals are beginning to emerge publicly. They include:

• Linking debt payments to growth
• Seeking help from other countries on more effective tax collection techniques
• Athens will present a comprehensive plan by June, but the ECB needs to fund the Greek banking system until then

As an initial negotiation position, these are not unreasonable proposals. I continue to believe that the Apocalyptic scenario of Grexit is off the table and a deal will be reached (see The (European) parents fight and the kids hear everything).

As an example, neo-Keynesian Paul Krugman outlined an extreme scenario where everyone could get part of what they wanted:

Greece has been running a primary surplus since 2013, and according to its agreements with the troika it’s supposed to run a surplus of 4.5 percent of GDP for many years to come. What would it mean to relax that target?

It would not mean demanding that creditors throw good money after bad; everyone has already implicitly acknowledged that the debt will never be fully paid at market rates, but Greece is making a transfer to its creditors by running a primary surplus, and we’re just arguing now about how big that transfer will be.

So let’s think of a maximalist case, in which Greece stopped running a primary surplus at all (this is not a proposal). You might think that this would let the Greeks spend an additional 4.5 percent of GDP — but the benefits to Greece would actually be much bigger than that. Remember, the main reason austerity has been so harsh is that cutting spending leads to economic contraction, which leads to lower revenues, which forces further cuts to hit the budget target. A relaxation of austerity would run this process in reverse; the extra spending would mean a stronger economy, which means more revenue, which means that the primary surplus wouldn’t fall as much.

Suppose that the multiplier is 1.3 — which is what IMF estimates seem to suggest — and that Greece can collect 40 percent of a rise in GDP in revenue (roughly matching its average revenue/GDP). Then an additional billion euros in spending should generate around 0.5 billion euros in revenue, reducing the primary surplus by only 0.5 billion euros.

And if you follow that through, you find that dropping the requirement that Greece run a primary surplus of 4.5 percent of GDP would allow spending to rise by 9 percent of GDP — twice as much — and that this would raise GDP by 12 percent relative to what it would have been otherwise. Unemployment would fall by around 10 percentage points relative to no relief.

OK, this is not going to happen — even in the best of circumstances, Syriza is going to be able to get a relaxation of the primary surplus requirement, not complete abrogation. But even a partial move in the direction I’ve described could have quite significant positive effects on Greek welfare.

SYRIZA gets more money to spend on social services. The debt doesn't get written off. Greece gets more growth and creditors eventually get paid off. (Note that I am not endorsing this proposal, but I bring it up to show that there is lots of wiggle room in negotiations.)


The ECB wildcard
The most immediate problem is the response of the ECB. Erkki Liikanen appeared to have drawn a line in the sand for Athens, but how serious is that line?

This Reuters report outlined the official ECB position (emphasis added):

ECB Vice-President Vitor Constancio said on Saturday that a decision on whether to give Greece emergency funding would be up to the central bank's Governing Council.

He was commenting on options available for Greek banks if the country's new anti-bailout government quits its EU/IMF program.

Constancio said that the central bank's emergency liquidity assistance (ELA) facility -- designed as a stop gap for banks facing temporary problems -- was an alternative to its regular funding, but its provision would need to be approved by the European Central Bank's 25-member Governing Council.

As this article indicates, the ECB has a history of strong-arming member states to bend to the Governing Council's will. While Liikanen's comments that the ECB has rules that it has to follow are true, it makes up those rules as it goes along.

The ECB is pretty clearly playing from its tried and tested playbook in their current stand-off with the Greek government. Governing Council members know they can cut off lots of credit from the Greek banks in March and many of them are happy to tell the world they are thinking about doing this. As a result, they hope to get Greece’s new government to sign a new deal with the EU and IMF.

But don’t believe for a minute that this is a technocratic thing to do with “the ECB having to follow its rules.” And it has almost nothing to do with Greek government bonds being junk-rated. All of the issues discussed above come down to discretionary decisions by the ECB Governing Council (restrictions on T-bills, waivers on junk-rated government bonds, arbitrary lines-in-the-sand on government guaranteed bonds and the mysterious rules of ELA) and there is plenty of wiggle room for them to allow Greek banks to continue receiving various sources of funding next month in the absence of an EU-IMF program agreement.

Stay tuned, we are just in Act 2 of a three act play. There is much more drama - and volatility to come. But you can more or less expect a happy ending.