Paola Subacchi
Research Director, International Economics
Negotiations over Greece's debt remain stuck in a feedback loop. But an end to the impasse is possible; it just might be painful.
A man walks in front of graffiti reading all to the streets as unions gather in Syntagma Square to protest against austerity measures. Photo by Getty Images.A man walks in front of graffiti reading 'all to the streets' as unions gather in Syntagma Square to protest against austerity measures. Photo by Getty Images.

If the ultimate purpose of the negotiations over Greece’s debt is to keep Greece in the eurozone and rebuild a sense of unity in the core of Europe, then the deal currently on the table is not going to serve its purpose. In fact, it will achieve exactly the opposite. This is not because the deal is, as some claim, particularly punitive or, as others claim, particularly lenient, but because the gap between Greece and its creditors is now so wide that finding a mutually acceptable solution is almost impossible. The only way out of this impasse is to change the narrative entirely and find alternate solutions to the problems.

Alternatives exist: offering Greece debt restructuring or helping Greece manage a default and temporarily leave Europe’s monetary union. Unlike any bailout, which will only buy time until Greece is in dire straits again, these two options could help Greece rebuild its economy (provided that structural reforms are implemented). However, they imply significant changes in the way the eurozone works.

Discontented politics

Stirring discontent and playing the blame game help neither Greece nor Europe. The point here is that Greece and its creditors have irreconcilable positions. The Greeks think that their 5 July referendum, in which an overwhelming majority rejected the proposed bailout conditions, gave them the right to negotiate a deal on their own terms. Now, as Prime Minister Alexis Tsipras capitulates, Greek voters feel that they are being forced, once again, to accept punitive austerity measures.

Hardly less goodwill is on the other side. Germany feels that too many rules have been broken in order to accommodate Greece’s requests and thus Germans are being forced to pay, once again, for a bailout of Greece. The response of other eurozone member states has been more muted — and fine-tuned to public opinion. Italy and France, both with centre-left governments but with significant Eurosceptic segments of the electorate, have been swinging between paying lip service to European solidarity and pushing the bailout on Greece.

At stake in this fight is the integrity of Europe’s monetary union. The costs of keeping Greece in the eurozone must be assessed against the costs of pushing it out. The costs of the former are another €86 billion for the third bailout, adding to approximately €240 billion for the first two bailouts, in addition to the huge amount of political capital spent over the last five years. The costs of a Grexit, on the other hand, are not clear yet. The financial instability will probably be manageable, but what will be the costs of a failed state in a critical region of Europe? By leaving the euro and losing European Central Bank (ECB) support for its banking system, Greece will almost certainly face a simultaneous banking crisis, balance-of-payment crisis, and political-institutional crisis. Greece’s domestic politics could become dangerously radicalized. If that happens, will Europe be able to help?

The emergency of an impending banking crisis in Greece and the need to stabilize the economy overlap with political difficulties. In all these months of painful negotiations with Greece’s creditors, Tsipras has managed to accomplish a rare achievement: unifying European elites. From Berlin to Brussels to Rome, distrust of Greece is universal. Meanwhile, the crisis has also brought to the surface Europe’s German problem and has managed to split the Troika (the ECB, the IMF, and the European Commission).

The way forward

The solution to the Greek puzzle and the euro dilemma lies in prioritizing. Insisting on structural reforms — a German obsession — when the banking system is on the verge of collapse is a waste of time. Greek banks are now the point of maximum vulnerability as a result of their protracted closure and the introduction of capital controls at the end of June. The ECB’s emergency funding of €89 billion has been essential to keeping Greek banks afloat. But further ECB emergency loans will be needed, not to mention €7 billion by 20 July for repayments to the ECB and the IMF; otherwise Greece will technically default. And a technical default will stop the ECB’s support to the Greek banking system.

In other words, emergency funding is needed just to keep the current situation in equilibrium while the terms of the bailout are being negotiated. The ECB has some room for maneuvering — it could, for example, increase emergency loans to Greek banks on the understanding that a bailout deal is under negotiation and that when it’s completed Greece will have new funds. As long as the negotiation on the bailout stays on, the ECB will continue to underpin Greece’s banking system.

This will only work, however, if the eurozone’s member states are prepared to accept that the third bailout will be just a palliative and won’t actually put a dent in Greece’s public debt. According to the IMF’s debt-sustainability analysis, under current conditions Greece’s debt will peak at almost 200 per cent of GDP in the next two years (from 177 per cent in 2014) and will be 170 per cent in 2022 (compared with a previous estimate of 142 per cent). To achieve this outcome, the IMF calculates that Greece will have to maintain a primary surplus of 3.5 per cent of GDP for several decades. This is a titanic effort that will require reforms of the pension system, the public administration, and the labor market. This is not a plausible scenario for Greece — or for any other country in a similar situation.

If the ultimate aim is to get Greece’s economy back into positive long-term growth after years of contraction — as opposed to just trying to squeeze money to repay creditors — then any solution must find a way to make the country’s debt sustainable. For this, there are two options: managed default or significant debt restructuring. Creditors are going to lose, whichever option they choose, and they need to make a bold decision on whether writing off loses today will avoid more loses in the future. And either would entail a radical change to the institutional design of Europe’s currency union.

A managed default — as opposed to an unmanaged one triggered by a collapse of the banking system — would transform the European monetary union by opening up the possibility, for the first time, that countries can leave it when they cannot manage required adjustments. Ideally, they would be able to rejoin when their economies were back on track. (This idea was proposed for Greece by German negotiators on 11 July.) A managed default of this type would likely involve the introduction of an 'interim' currency

Debt restructuring, on the other hand, would put the burden on other eurozone member states and make clear that the priority is on keeping the monetary union together. It would also be a first step toward more burden-sharing and a more effective mechanism for crisis resolution. And this would have the advantage of avoiding legal questions about whether the departure of Greece from the monetary union would affect its EU membership. (With the exception of the United Kingdom and Denmark, all members of the European Union have to eventually be part of the currency union.)

In a typical European fashion, neither of these options has to really be put forward. Instead, discussions over a third bailout continue, ignoring the long-term challenges. Unlike in the past, however, when draconian measures of fiscal consolidation were confused with structural reforms, it is now crystal clear that the terms of the proposed bailout are unsustainable. Making strenuous efforts to meet impossible targets is the perfect recipe to radicalize a euro-exhausted public. And a Greek collapse will send the wrong message about the costs of being in Europe.

This article was originally published in Foreign Policy.

To comment on this article, please contact Chatham House Feedback