- How the hard-line approach taken by the IMF and Germany, against the pluck shown by Greece not to be bullied into oblivion (and, in so doing, courting economic collapse?), is explained by game theory is the subject of an article by Partha Gangopadhyay (University of Western Sydney).
- Barry Eichengreen (University of California, Berkeley) reviews his original prediction that an exit from the eurozone would never occur, and why that turned out to be incorrect—albeit, in an extreme situation characterised by political incompetence and perhaps even a disregard for economic sensibility.
- André Broome (University of Warwick) explains why the IMF has become the enforcer of controversial structural reforms to a country experiencing severe economic distress, the social consequences of which have been disastrous over the last seven years.
- Wesley Widmaier (Griffith University) explains that the early European ideal was not about free trade or convertible currencies—it was about enhancing the collective welfare as a means to political union. However, the economic dog nevertheless came to wag the collective welfare tail, leading to a shift toward more free market, hard money views.The result would see European economic institutions evolve to such an extent that they place financial rectitude and monetary stability ahead of growth.
Partha Gangopadhyay
The world will come to an eerie halt in the first week of July to watch the unfortunate endgame fast unfolding between Greece and its creditors. It has been a pretty ugly and detestable squabble over $70 billion that, according to some, has cost roughly about $1 trillion already.
Many trillions will be down the gurgler, yet there is absolutely no economic fulcrum on which the impasse has been pivoting. In order to understand the dynamics of failed negotiations and continuing conflicts between the troika and the Greek government let me borrow the much-celebrated parable from 2005 prize-winning game theorists, Thomas Schelling and Robert Aumann.
The theory of conflict and cooperation
Imagine that the Greek government is placed at the edge of a precipice, restrained by a chain that is tied to its ankle and then fastened to the ankle of the troika.
Both will be rescued and only one of them will win a large prize (read vain-glory) as soon as the other rolls over. Thomas Schelling posited that each party has only one method to persuade the other to give in - namely, threatening to push the other off the precipice.
The threat is not credible since a big push will ensure doom for both. A big push is thus nothing but collective lunacy. Yet each side has an incentive to dance recklessly close to the precipice to convince the other that one is stupid enough to embrace a higher risk to create an accidental annihilation of both.
Whoever can dance more recklessly will win the game, which is figuratively a race to the bottom. There is some evidence that the troika has outsmarted the Greek government in terms of its reckless behaviour. Consequently, the troika has imposed a new, punitive and more devastating austerity package on the Greek government in its latest round of negotiations.
In other words, the Greek government could not signal sufficient recklessness to the troika and is, hence, staring down the barrel of another bout of policy-driven deep recessions that the troika seeks to dump on Greeks.
Politics, not economics
Most impartial observers will find it difficult not to think that economics was just the façade under which dirty power-games, domination, arm-twisting and negative politics had vitiated the negotiation process. Any decent economist with a modest track-record would fail to decipher the economic rationale behind the troika’s policy prescriptions for Greece since 2010.
Most Goliaths in economics have unequivocally opposed the adjustment programs imposed by the troika on Greece, which sent the Greek economy into deep crisis and the resulting GDP decline of 25% since 2010. The welfare implications of this are stark and confronting: there are now 1 million households in Greece who survive only on pensions of grandparents while youth unemployment has shot past 60%. The string of pigheaded policy blunders of the troika created crises after crises in Greece.
It seems the troika has no accountability whatsoever as it now demands a further restraint on the government spending for Greece to achieve a budget surplus of 3.5% by 2018.
This will spell further economic doom for the ailing Greek economy, as most economists will argue, economic depression will never leave the Greek soil and most Greek households will suffer untold miseries from a further contraction of the economy. So, the referendum will be a test on the Greek penchant for masochism: how much more pain can the Greek people absorb by supporting the ludicrous austerity measures and violent reform packages of the troika?
The devil you know - or the unfathomable unknown?
Back to the application of game theory: the rejection of the package will have potentially unfathomable adverse consequences for Greece. So, the Greek voters now face an unusual dilemma: they either approve the known devil – the austerity- they have been living with during the last five dreadful years. Alternatively, they put the austerity package in the bin and walk out of the eurozone, regaining control over monetary policy from the European Central Bank (ECB) and putting up a real fight to drive off recessions out of Greece.
Yet the Greek voters, however insulted they are by the troika, cannot gauge the potential risk from breaking away from the ECB and then possibly from the EU. Though many pundits believe the Greeks will happily choose a punitive strategy in the referendum in order to punish the troika by dismembering the eurozone, the picture is not at all clear. The fear of unknown and unfathomable consequences from the separation from the ECB can persuade the voters to herd with others by meekly rubber-stamping the austerity package of the troika.
The potential presence of herd mentality in voting can create a socially inefficient, erroneous and possibly profligate outcome in Greece since – despite a plethora of private signals that reveal the right choice/action – voters can still herd on the incorrect and costly choice of new austerity measures with a positive probability.
One can thus never be sure what will be outcome of the referendum in Greece - it is rather unpredictable, which makes the Greek referendum all the more interesting.
Path to Grexit tragedy paved by political incompetence
Barry Eichengreen
Since our last episode, the crisis in Greece has escalated further. Negotiations between the government and its creditors collapsed over the weekend, and restrictions on bank withdrawals will now follow.
The next step is for the government to issue the equivalent of IOUs to pay salaries and pensions. The country is seemingly on the slippery slope to exiting the euro.
Many of us doubted that it would come to this. In particular, I doubted that it would come to this.
Nearly a decade ago, I analysed scenarios for a country leaving the eurozone. I concluded that this was exceedingly unlikely to happen. The probability of a Grexit, or any Otherexit, I confidently asserted, was vanishingly small.
My friend and UC Berkeley colleague Brad DeLong regularly reminds us of the need to “mark our views to market.” So where did this prediction go wrong?
Why a euro exit didn't make sense
My analysis was based on a comparison of economic costs and benefits of a country exiting the euro. The costs, I concluded, would be severe and heavily front-loaded.
Raising the possibility, however remote, of exit from the euro would ignite a bank run in said country. The authorities would be forced to shutter the financial system. Economic activity would grind to a halt. Losing access to not just their savings but also imported petrol, medicines and foodstuffs, angry citizens would take to the streets.
Not only would any subsequent benefits, by comparison, be delayed, but they would be disappointingly small.
With the government printing money to finance its spending, inflation would accelerate, and any improvement in export competitiveness due to depreciation of the newly reintroduced national currency would prove ephemeral.
In Greece’s case, moreover, there is the problem that the country’s leading export, refined petroleum, is priced in dollars and relies on imported oil, which is also priced in dollars. So much for the advantages of a depreciated currency.
Agricultural exports for their part will take several harvests to ramp up. And attracting more tourists won’t be easy against a drumbeat of political unrest.
What went wrong?
How did Greece end up in this pickle? Some say that the spectre of a bank run was no longer a deterrent to exit once that bank run started anyway due to the deep depression into which the Greek economy had sunk.
But what is remarkable is how the so-called bank run remained a jog – it was still perfectly manageable until the Greek government called its referendum on the terms of the bail out deal offered by international creditors, negotiations broke down and exit became a real possibility.
Non-performing loans — ones that are in default or close to it — were already rising, to be sure, but the banks still had all the liquidity they needed. The European Central Bank supported the Greek banking system with emergency liquidity assistance (ELA) right up to the very end of June. Only when Greece stopped negotiating did the Central Bank stop increasing ELA. And only then did a full-fledged bank run break out.
So I stand by the economic argument. Where I need to mark my views to market, however, is for underestimating the role of politics. In particular, I underestimated the extent of political incompetence – not just of the Greek government but even more so of its creditors.
In January Syriza had run on a platform of no more spending cuts or tax increases but also of keeping the euro. It should have anticipated that some compromise would be needed to square this circle. In the event, that realization was strangely late in coming.
And Prime Minister Alexis Tsipras and his government should have had the courage of its convictions. If it was unwilling to accept the creditors’ final offer, then it should have stated its refusal, pure and simple. If it preferred to continue negotiating, then it should have continued negotiating. The decision to call a referendum in midstream only heightened uncertainty. It was a transparent effort to evade responsibility. It was the action of leaders more interested in retaining office than in minimizing the cost to the country of the crisis.
[Editor's Note: I don't agree this is incompetence on the part of Greece's leadership; rather, Greece was really left with no option but to call the bluff of the European troika, as was explained in the first article by Partha Gangopadhyay.]
A hard lesson learned
Still, this incompetence pales in comparison with that of the European Commission, the ECB and the IMF.
The three institutions opposed debt restructuring in 2010 when the crisis still could have been resolved at low cost. They continued to resist it in 2015, when a debt write-down was the obvious concession to Mr Tsipras & Company. The cost would have been small. Pretending instead that Greece’s debts could be repaid hardly enhanced their credibility.
Instead, the creditors first calculated the size of the primary budget surpluses that Greece would have to run in order to hypothetically repay its debt. They then required the government to raise taxes and cut spending sufficiently to produce those surpluses.
They ignored the fact that, in so doing, they consigned the country to an even deeper depression. By privileging their own balance sheets, they got the Greek government and the outcome they deserved.
The implication is clear. Never underestimate the ability of politicians to do the wrong thing. I will try to remember next time.
Five things you need to know about the IMF’s stance on Greece
André Broome
As negotiations go down to the wire, the IMF is once again being cast in the role of dictator. It is the enforcer of controversial structural reforms to a country experiencing severe economic distress, the social consequences of which have been disastrous over the last seven years. In many ways, however, the IMF is used as a scapegoat for promoting unpopular policy choices by the elected politicians and unelected bureaucrats of the eurozone who are well aware of the organisation’s fundamental commitment to favouring fiscal consolidation.
Here are the five key things to know about the IMF’s position.
1. Keeping the eurozone in tact
Keeping the eurozone together is a paramount concern for IMF negotiators. They will therefore almost certainly not recommend that Greece consider taking the nuclear option of abandoning the euro, which would be the likely result of defaulting on its debts.
This is because of the risk of systemic instability. And also because of the potential for eurozone rules to act as an external constraint on future economic policy choices in Greece – which the IMF has long seen as in need of further structural reforms and greater fiscal discipline.
Plus the organisation has a long history of exhibiting a status quo bias whenever it has been faced with the possibility of regional monetary disintegration, such as in the case of the rouble zone during 1991-93.
[Editor's note: In case this point isn't obvious, the troika's stance is as much a deterrent for other potential fiscally recalcitrant eurozone members as it is punishment for Greece's recalcitrance.]
2. Reputational costs
The IMF is acutely aware of the reputational costs it faces if it is blamed for a sovereign default by Greece – let alone if Greece is eventually forced out of the euro. Here, the stakes involved with the terms of the Greek bailout, and whether or not Greece remains in the euro, differ markedly for the IMF compared with its “Troika” partners, the European Central Bank and the European Commission.
After the IMF took the lead in coordinating a multilateral response to the Asian financial crisis in 1997-98 it shouldered most of the blame for policy mistakes that inflamed the crisis. This motivated many countries to shun the organisation over the next decade until the onset of the global financial crisis in 2008.
There can be no real winners from the high stakes poker match between Greece, the EU, and the IMF that has been running since the Syriza-led coalition came to power in January. But how the IMF’s reputation fares in the aftermath of the eurozone crisis will have a significant impact on its future crisis management role, both in Europe and beyond.
This is one of the reasons behind the IMF’s decision in 2013 to publicly admit to making notable errors in underestimating the damage that the initial round of austerity policies in 2010-11 would do to the Greek economy. This acknowledgement helped to place a small amount of distance between the IMF’s position and the apparent commitment of EU leaders to austerity-at-any-cost, while reducing the potential for the IMF to be used as the scapegoat for mistakes also made by its Troika partners.
A concern with protecting its reputation is also why the IMF has been at pains to emphasise in press briefings that it has pushed for “social fairness and social balance” in the design of reforms to the Greek pension system.
3. Greece’s commitment to structural reform
How flexible the IMF will be in reaching a compromise with the Greek government depends in large part on how they assess Greece’s commitment to implementing structural economic reforms.
Since it was elected, the Syriza government has demonstrated little or no political will for implementing major overhauls of the pensions system and the tax system, which are key concerns for the IMF.
A broader issue here is the IMF’s principle of “uniformity of treatment” for borrowers. There will inevitably be internal debates over how much the IMF should compromise with Greece over its bailout terms. But this principle constrains how flexible the organisation can be seen to be for any individual country, to avoid future borrowers also demanding softer loan conditions such as through looser policy targets or a slower pace of structural reforms.
4. Views on tax reform
The IMF’s long-standing views on tax reform also limit its flexibility towards Greece’s recent proposals for tax rises. Here, as in other countries, the IMF is seeking a substantial broadening of the tax base through the expansion and simplification of consumption taxes.
It is concerned that tax increases alone cannot plug the fiscal gap in a country with a notoriously leaky tax system. Though much of Syriza’s proposed changes may increase tax revenue in the short-term, the IMF is more interested in structural reform of the tax system that can help in shaping long-term policy.
In the meantime, cutting public spending in Greece, from the IMF’s perspective, is both easier for the government to achieve as a stopgap solution and is a better indicator for the country’s creditors of the government’s political commitment to implementing painful reforms.
5. Leadership
During the four years that former French finance minister Christine Lagarde has served as the IMF Managing Director, her public comments on Greece have gradually moved towards recognition of the need for debt relief. This is a significant shift from the organisation’s official position in 2010-11, and has expanded the negotiating space available to the IMF. Meanwhile it has placed pressure on its Troika partners to deliver some form of debt relief down the track.
Yet despite growing acknowledgement that debt relief will need to be part of any long-term agreement to achieve fiscal stability in Greece, this is only likely to be formally placed on the negotiating table after the government first agrees to a comprehensive package of structural reforms.
[Editor's note: In Australia, economic tensions within in our monetary union are smoothed through a complicated system of fiscal transfers between the States facilitated by the Commonwealth. In comparison, Europe has always pretended that the eurozone could be held together only by monetary policy and political will. Debt forgiveness, funded in a myriad of possible ways ultimately by Germany and France, would be the equivalent of a fiscal pressure relief valve for Greece.]
The end game
As the negotiations over Greece’s economic future enter the end game, the chasm between the debtor country and its creditors remains both wide and deep. The carrot of debt relief is only likely to materialise once substantial progress is made on implementing the structural reforms that have been deemed unacceptable by Greece’s Syriza government.
It is hard to imagine how a workable long-term solution can be fudged at this stage of the process. This would need either the creditors relaxing their demands for continued austerity or the government caving in and accepting the structural reforms it campaigned against in the election in January. The former is highly unlikely, given the signal this would send to other economies. The latter seems equally unlikely and if it happens might result in the collapse of the government and fresh elections, starting the messy process of muddling through negotiations all over again.
Eurozone’s shared identity the final tragedy of the Greek crisis
Wesley Widmaier
Economic policy is not a morality tale. The Greek tragedy is that the Europeans have treated the Greek crisis as a question of national character. In their outrage at the Greeks – in the context of broader view of austerity as the way out of the European crisis – they have not only weakened their collective economies, but also jeopardised the fate of the European experiment itself.
The risk is that the larger goal of the European project – to create a sense of shared identity – may be undermined by an incidental economic means to that end, in the creation of a euro – a mechanism of economic discipline.
The reasons for this tragedy go deep into European history. Coming out of World War II, European leaders decided nationalist excesses should never again be permitted to divide their people. They therefore sought to create a supranational union, one that would unite the continent in a common vision. In 1950, French Foreign Minister Robert Schuman proposed the establishment of the original European Coal and Steel Community – the grandfather to the modern EU – as a way to “make war not only unthinkable but materially impossible”.
Ironically, given what the Euro has become, Schuman’s vision was never based on any commitments to “hard money” or free trade. Quite the opposite. The tragedies of the 1930s were widely attributed to a classical gold standard that had enforced austerity on the European people. As the European economies collapsed in the early 1930s, states were forced to cut spending and raise taxes – contributing to an ever-worsening slump.
In contrast, the point of the European Coal and Steel Community was to raise the prices of its members’ commodity and manufacturing exports. The ECSC would do this by enabling its initial six countries – most importantly, including France and Germany – to collude and fix coal and steel prices. In this sense, the early European ideal was not about free trade or convertible currencies – it was about enhancing the collective welfare as a means to political union.
Over the decades to follow, the economic dog nevertheless came to wag the collective welfare tail. As the German economy grew more important, German influences in European economic institutions would increase – leading to a shift toward more free market, hard money views. There were deep cultural reasons for this: German memories of the 1920s were of hyperinflation, while the German successes of the 1930s in using fiscal stimulus were repressed from collective memory, for obvious reasons.
The result would see European economic institutions – most notably the European Central Bank – evolve and place financial rectitude and monetary stability ahead of growth. This has been the case even when intellectual arguments for austerity – primarily as a means to limit inflation – make little sense, as the high unemployment of recent years has broken any link between fiscal deficits and inflation.
Large deficits absent full employment are not a problem – they are the solution, enabling revived growth. Greek austerity only makes Greek repayment more difficult, whatever one’s view of their pension system.
Over the past five years, the EU has taken what should have been a practical matter of economic policy – to run deficits during a recession – and turned it into a morality tale.
Internal Greek politics have nothing to do with the macroeconomic needs of the European Union – which would benefit from debt forgiveness across the continent to enable rising demand. On top of this economic malpractice, one can superimpose political error, as austerity politics have revived political extremism and nationalist sentiment across the continent. This is the very essence of a tragedy – as the post-war European dream may be undermined by incidental mechanisms established to bring it into being.
These articles are republished under Creative Commons licence.
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