Negotiating Greece's Debt Is Risky Business

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Includes: GREK
by: Global Risk Insights

Call it moral hazard or moral responsibility, but the Greek leadership of Syriza is pushing Europe hard to renegotiate its bailout.

"We cannot find the truth on our own, but we can open a door and move so that you can join us," Greek Finance Minister Yanis Varoufakis told an Italian television station last week. "This way, we will be able to leave the darkness of present austerity and enter into the light of a European rational and sober discussion."

In a hectic few weeks acting as envoy for Greece's governing Syriza party, the economics professor-cum-rabble-rousing politician has tried to begin a genuine conversation that Europe does not want to have. Even if those discussions will be hard to have - and a compromise even harder - both Greece and the EU would be stronger if they can come to a compromise while keeping the Eurozone intact.

The difficulty will be in finding a solution that satisfies both Greek and European needs and, more importantly, one that can survive the blustery negotiations intact.

Getting away from the more sensational story-lines of Varoufakis's European road show - his casual attire at Downing Street or how German Finance Minister Scheuble is his polar opposite in every way - he has set out to address Greece's two main problems: it has too much debt and not enough growth.

Debt-to-GDP currently sits at 175% and the austerity it agreed to in order to receive those loans during the Euro Crisis have helped to hold down what was already a disaster of an economy. Greece has logged 6 straight years of negative growth.

Varoufakis is in a precarious position in negotiations. Not only is he asking for flexibility from the same politicians Syriza vilified to win last month's election, but he is not even a member of that party. His demands are already more tempered than the rhetoric of the PM, which puts him in danger of losing support from the cabinet before having a chance to finish negotiations.

Essentially, Varoufakis is standing in as the mediator between two parties deeply suspicious of each other. Greece is more willing to negotiate than Germany and the larger EU, but that fact results more from its lack of power in the situation than anything else.

The key to compromise: restructured debt

Varoufakis's out-of-the-gate proposal for growth-linked bonds is, in a way, a brilliant solution, addressing both of Greece's real problems: mammoth debt-servicing costs and crushing austerity. For the rest of Europe's part, Greece remains responsible for paying back its debts in whole. The point that raises concern is that it allows Greece to keep running a budget surplus while easing the pain of austerity on its besieged economy by lowering interest payments.

If there is a sticking point, it is the potential that it would undermine Germany's credibility in enforcing rigid contracts - which it has seemingly prided itself on. But in negotiations like this, an old song becomes instructive: If you owe €100, it is your problem. If you owe €1,000,000, it's your creditors' problem. Default would be destructive for not only Greece, but the IMF, ECB, and EU as well.

Separate from their political viability, growth-linked bonds theoretically would boost Greece's economy. Looking at Robert Lucas' famous exchange economy model (which forms a basis for a large portion of macroeconomic models today), economies suffer when consumers have uncertainty about their future income after debt payment - just like in Greece today.

Growth-linked bonds fix this uncertainty by tying debt payments to increases in GDP. While there is still uncertainty in this model, there is no need for precautionary saving at the expense of the economy today since any given year's debt payments would adjust. Instead, more income is spent today and the economy is stimulated relative to the alternative.

If there is one reason that growth-linked bonds have not yet been agreed to - beyond any objection to their substance - it is that Varoufakis suggested them too early. Suggesting them as a first offer may have been too weak, meaning that Germany and Europe's counteroffer could be less generous. In practice, Scheuble's position has only evolved from 'no negotiation' to 'agree to disagree.'

Of course, in the context of Varoufakis's de facto role as a mediator for Syriza and Germany, the suggestion of growth-linked bonds is a sensible suggestion. He just played his hand too soon. Perhaps by positioning himself as a good-faith and pragmatic negotiator, he will be able to bring growth-linked bonds back into play. After Prime Minister Tsipras' tearful speech to Greek Parliament Sunday - in which he called for German reparations for World War II - Varoufakis positioning himself as a good-faith negotiator may become untenable.

Other intriguing ideas have been put forward, like issuing undated bearer bonds or paying for social services with IOUs, but they lack the simplicity and aligned-incentives of growth-linked bonds.

The timeline for any of these solutions to precipitate is running short, however. Greece only has enough money to avoid default until June or July. After that, Greece only has the tough road to follow - Grexit and massive devaluation of the new drachma. The timeline was squeezed even shorter last week when the ECB cut its waiver on use of Greek government debt as bank collateral.

Although the move was portrayed as a way for the ECB to remain neutral in negotiations, it seems like a much more meddling in negotiations to put pressure on Syriza to give up its appeal for restraint from Europe.

Now, in order for Greek banks to make up any gaps in their required capital - which are large since depositors withdrew €9 billion in January alone - it must use Emergency Liquidity Assistance (ELA) from the Bank of Greece. Not only does ELA cost more for banks, but the ECB has the power to limit ELA at any time as well. This leaves all eyes on the February 18 meeting of the ECB Governing Council to see whether it will put even more pressure on the Greek banking system.

Regardless of today's particular politics and circumstances, a Greek exit from the Euro would be an ultimate failure - especially for the French and Germans who have been at the center of the European experiment since it was a coal and steel trade organization. If Greece has one leverage point, this is it.