It looks increasingly likely that Greece?s political elite and social partners – such as the trade unions, the employers? associations and others – on one hand and the European Union on the other, will face a critical dilemma in the next few weeks, months or quarters choosing between a hard default or a soft default scenario.
Any suggestion at the end of 2009 that a eurozone country would have been forced to seek IMF financing a few months later would not have been taken seriously. Yet, this is what happened a few months later thanks to a large extent to the mismanagement of the crisis by the Greek side.
The pressure of time to avoid a default and the relatively limited experience of Greek officials involved in the negotiations with the EU and IMF officials produced an economic program that failed to recognize that the country faced a solvency rather than a liquidity crisis.
Sometime in the fall of 2010, the troika – namely the representatives of the European Commission, the IMF and the ECB (European Central Bank) – must have recognized that the main goal of the program was not going to be fulfilled. In other words, Greece would not gain access to the world capital markets by early 2012 at the latest as envisaged.
Around that time or a bit later, the troika must have also recognized that implementation of the economic program was not going well. After a strong start marked by legislation to overhaul the ailing social security system, some spending cuts and many tax hikes, the government dragged its feet.
By spring 2011, it must have become clear Greece was lagging behind in the implementation of the program on both fronts: structural reforms and fiscal consolidation. Faced with the prospect of contagion of the Greek debt crisis to other vulnerable eurozone countries, especially Italy and Spain, and the choice between integration and disintegration of the eurozone, the EU leaders decided ?to support last July a new program for Greece and, together with the IMF and the voluntary contribution of the private sector, to fully cover the financing gap.?
The approval of the midterm fiscal strategy by Greek Parliament helped a lot to that end since the other governments could sell the new austerity program to their constituencies. But the EU summit?s decision was political and had to be converted into technical terms before heading for approval at national parliaments.
The problems that have arisen with Finland?s demand for collateral to back the new loan and signs that private sector participation in the second Greek bailout is not proceeding as expected or hoped for apparently have not helped sentiment and have clouded the prospects for the second package.
But nothing did more to cloud the prospects more than the temporary halt of the negotiations between the government and the troika late last week. It was by any account a serious development, given that the previous loan tranche of 12 billion euros from the first rescue package of 110 billion euros had been released although Greece had not fully met the conditions of the program.
At this point, the government appears to want a so-called ?political? solution at the highest EU level that translates into providing Greece the same amount of financing under the second bailout program – 109 billion euros of official loans – while allowing the country to miss the budget deficit target this year and perhaps next in exchange for some upfront structural reforms. Whether this is politically acceptable by the other EU leaders remains to be seen.
However, the Greek side should note that more and more EU officials and some market participants increasingly see the country as a special case. This may eventually lead to a market differentiation between Greece and the rest of the eurozone periphery, namely Portugal and Ireland, on one hand and isolate it from Spain and Italy as well.
There is no doubt that Greece?s problem was a complex one from the beginning. On the one hand, the country had to tackle its large budget deficit, underpinning a high and fast rising public debt-to-GDP ratio, and on the other it had to improve the eroded competitiveness of its economy without controlling its own currency.
Yet slashing the budget deficit by increasing taxes and cutting spending in a frontloaded fiscal consolidation program to help restore market confidence in the country?s public finances soon also meant the Greek economy would have to suffer a deeper recession than otherwise thought.
The hope of the planners was that structural reforms and successful fiscal consolidation would have teamed up to pull the economy out of recession relatively soon. In so doing, they did not pay enough attention to the fact that structural reforms, even when implemented, take some time to bear fruit, and that the local economy was a relatively closed one, meaning it cannot count on the external sector, i.e. exports, to pull it out of recession like Ireland.
In past episodes of successful fiscal consolidation, countries could regain competitiveness relatively quickly by letting their national currency depreciate against the others. By being a member of the eurozone, however, Greece did not have such a luxury.
But going through a period of deflation and fiscal consolidation without the benefit of depreciation means a protracted recession which may not be politically and socially acceptable after a while. We are not sure whether Greece has reached the threshold of pain – perhaps not – but it is clearly heading there.
In situations like this and given all the obstacles the government and the political establishment brings to the fore, Greece and its EU partners will have to make a decision at some point down the road. This means restructuring the Greek debt in a way so that the debt-to-GDP ratio falls considerably, perhaps close to 100 percent from an estimated 166 percent this year before the impact from PSI (Private Sector Involvement).
Whether this leads to a hard default and the exit of Greece from the eurozone or a soft default will have to be decided.
It is clear to us that the EU leadership has grown increasingly disenchanted with Greece. Therefore, any concession on a large-scale restructuring of the Greek debt will hinge both on their estimates about the possible impact from contagion to other europeriphery countries and the so-called moral hazard problem. The latter refers to putting Greece under less pressure to achieve a primary surplus and implement structural reforms.
So, if they decide to give Greece another go, the country will have to give a lot in return, such as constitutional limit to the budget deficit, to counter moral hazard.
This is the soft default scenario. This would have been unimaginable a few months ago but it is possible now as reform and fiscal consolidation fatigue has gripped Greece.
The worst is what some call the hard default scenario. Here, the EU pulls the plug, recognizing that Greece is a basket case or/and that the Greek political elite and social partners cannot honor their commitments.
Neither scenario is good for the country, especially the hard default one. However, they can no longer be dismissed.