In the fall of 2008, US authorities conducted a financial market experiment. They allowed a large and heavily interconnected firm, Lehman Brothers, to file for bankruptcy, apparently under the belief that the consequences should be limited as everyone knew this was coming. I think that, in retrospect, US policymakers wished they had pursued an alternative path. The experiment was not exactly successful.
Now it seems that European policymakers are willing to risk yet another such experiment. To be sure, they could still pull the rabbit out of the hat, but it is starting to look like the Troika and Greece have what they call in divorce court “irreconcilable differences.” Via the Financial Times:
Lucas Papademos, the Greek premier, failed to make party leaders accept harsh terms in return for a second €130bn bail-out, pushing Athens closer to a disorderly default as early as next month…
…After five hours of discussions, the three leaders of Greece’s national unity government had not accepted demands by international lenders for immediate deep spending cuts and labour market reforms as part of a new medium-term package.
The Troika does not look ready to back down either:
The talks with the three leaders of a national unity government came after the government failed to persuade the so-called “troika”– representatives of the European Commission, European Central Bank and International Monetary Fund – to ease conditions for the rescue deal.
Patience with Greek politicians has evaporated among its creditors. During a conference call on Saturday, eurozone finance ministers bluntly told Athens to deliver on its promises and agree to reforms or face default next month.
Apparently, the Troika is playing serious hardball:
Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.
Now, perhaps Greece’s leaders are just putting up a fight to look good to their voters and thus this will all blow over tomorrow morning with another last minute deal cobbled together that no one really believes will work. Indeed, everyone already knows the numbers are too small:
A further complication is the uncertainty over supplementing the €130bn bail-out to take account of the deteriorating economic position in Greece.
Some officials believe around another €15bn is needed – funds that Germany and other countries have said they are unwilling to provide.
It doesn’t really make sense for Greece to accept a deal they know is doomed to failure from the start. Especially as the terms of the deal – including a steep wage cut to improve competiveness – is virtually guaranteed to plunge the Greek economy deeper into recession.
Fundamentally, the problem is as it always was – any decent adjustment program has the stick and the carrot. The carrot usually comes partly in the form of a currency devaluation that accelerates the process of adjustment by providing stimulus via the external accounts. This short-run stimulus allows for structural changes to take root. The approach to Greece has always been just the stick – more austerity and structural change, no carrot.
And I have to admit that I find the enforced wage-cutting a draconian solution. Will this policy eventually be applied to Spain and Portugal and Ireland? Is this the future of Eurozone economic policy? There are two ways to reduce competitive imbalances. Inflate German wages up, or deflate everyone else down. I think the former would prove to be a lot more fun than the latter.
Truth be told, I honestly believe that Greece is beyond saving without a significant transfer, not loan, that buys real time for the Greek economy to adjust. That is the only way to compensate for the lack of currency adjustment and is the conclusion I wish the Troika would ultimately reach. But, I am also starting to think that the ECB has made the Troika overconfident. When the ECB finally decided that yes, serving as lender of last resort, at least to the financial system, is actually the job of a central bank, they dramatically eased financial market stress throughout Europe. That stress, however, was Greece’s leverage. Absent that stress, the Troika appears to believe Greece is backed into a corner with no other way out but to submit to Troika demands.
This is a dangerous game. Sometimes the person backed into a corner makes a suicide run at their attackers. And maybe Greece has nothing else to lose at this point. To be sure, they will suffer a devastating blow if they exit the Euro, but at least it will be the process of self-determination, rather than the devastating blow of Troika imposed austerity.
And, while I am thinking about it, what exactly is the policy precedent the Troika is trying to set? That it is acceptable to force European citizens – a whole people – into poverty? When does this become a human rights issue?
In any event, I don’t think financial market participants are really prepared for Greece to make a suicide run. Why should they be? This whole episode is like The Boy Who Cried Wolf. Everytime we come to the brink, and prognosticators call for the apocalypse, someone backs down. Why should this time be any different? Honestly, it is tough to argue with that logic. Expectations of imminent financial crisis have simply gone unmet, leaving markets relatively unphased by the most recent events in Greece. Perhaps the ECB has done enough to let Greece slide out of the Euro without much noise.
It would be an interesting experiment to see unfold. I am curious to see if the ECB has indeed done enough. Not curious enough, however, to want to take such a risk. The Boy Who Cried Wolf ultimately had a poor ending.
This post originally appeared at Tim Duy’s Fed Watch and is posted with permission.