Reading between the lines of Greece's bailout: debt relief is inevitable -- just not yet

At first glance, the latest developments in the Greek bailout saga seem a little puzzling, particularly those concerning debt relief.

The current proposal from Greece’s eurozone creditors does not offer debt relief. To the contrary, it emphasizes that debt relief is not involved: “nominal haircuts on the debt cannot be undertaken.”

Yet the day after Greece agreed to the proposal, the International Monetary Fund released a report showing that Greece cannot possibly pay back its current debt. This position is hardly surprising in itself -– the IMF has been saying as much for months. But the timing was mystifying because the IMF had initially endorsed the proposal. In fact the eurozone countries would not have agreed to the proposal otherwise.

Truth be told, no one seems to think the latest bailout (alone) will work, the official word notwithstanding. Whether it’s the German finance minister, the Greek prime minister who agreed to the deal, the head of the IMF or the pundits, there’s a “Greek” chorus in the background wailing that this bailout will just bring another crisis.

In other words, it’s a puzzle any way you look at it. If debt relief will ultimately be essential, why not just provide it now? Why insist on fiscal and structural reforms that will increase Greece’s economic pain?

Could it be that eurozone leaders are simply setting the stage, however quietly, for significant debt forgiveness in the not-too-distant future?

Here’s why that idea may not be so far-fetched – and why there probably isn’t any better time than now, with Greece’s banks in crisis, to pursue reforms as a step toward debt relief. We just need to read between the lines.

Why debt relief must wait

First of all, proposing debt relief today would be politically dangerous for leaders in the eurozone creditor countries. Their voters do not trust Greece, given the country’s many unfulfilled promises of reform, and many view debt forgiveness as unfair.

It’s difficult for pensioners in Latvia, who retire on average at 63, to see why it’s fair for them to sacrifice to help pensioners in Greece, who retire on average at 60 – and sometimes at 50. It’s difficult for voters in Finland, who pay a value-added tax (VAT) of 24%, to see why it’s fair for them to be taxed to support voters on Greek islands, many of whom pay a VAT of only 13%.

So Europe’s leaders face a catch-22. Greece cannot recover without debt relief, but Europe’s voters will not approve such forgiveness. To complicate matters further, the Greeks think they merit relief since they have already implemented some reforms and their economy is suffering.

Economic activity is down by almost 30% since 2008. Prices are falling 2% per year. The banks are still closed, limiting Greeks to withdrawals of just €60 a day. Overall unemployment is 26%, and unemployment among the young is 50%. Homeless shelters are overwhelmed. Proper medical care is out of reach for many people.

Naturally the Greeks think they’ve suffered enough.

Why insist on reform amidst the ruins

Given the terrible economic pain in Greece, why do its eurozone creditors insist on fiscal and structural reforms that will make things even worse? Reform is critical financially, economically and politically.

Greece already owes more than it can pay, yet Greece’s government keeps borrowing more because it still runs a substantial budget deficit every year.

The bailout plan requires fiscal reforms that will dramatically reduce the need for borrowing: Greece must bring its pension system to financial sustainability via “comprehensive reform,” streamline VAT and broaden the tax base and introduce “quasi-automatic spending cuts" that kick in if the government can’t hit its targets.

Sustainable economic growth also requires structural reform. Existing Greek laws and regulations severely impede business activity and strangle job creation, all of which reduce tax revenues and make it hard for Greece to balance its budget. The deal aims to enhance competition, introduce greater labor-market flexibility and privatize certain industries.

History shows that these reforms will make a big difference to Greece’s economy. Similar reforms brought Germany to economic dominance within Europe and enabled China to explode onto the world economic scene. And the reforms are likely to pass: most Greeks strongly support their country’s membership in the eurozone and are willing to pay a steep price to keep it.

But the political benefits of reform are just as critical as their financial and economic benefits. By implementing the reforms, Greece could alleviate voter distrust among its creditor countries and reduce the perceived unfairness in debt relief. Thus the deal could ultimately make it politically feasible for leaders in these countries to propose significant forgiveness.

The adjustments associated with reform will be very painful, and the Greek economy is already in bad shape. Indeed, it was to avoid such pain, or at least spread it out, that Greek voters so often opted to slow or stop reform in the past. Unfortunately, slowing reform over the past year led the country into greater debt, precipitating the current crisis, so the rest of Europe will no longer support that option.

And the one option still available to Greece -– spurning its creditors altogether –- would be even worse than reform because it would intensify the banking crisis.

Banking crisis boosts Europe’s leverage

It is the banking crisis – which began after Prime Minister Alexis Tsipras surprised everyone in late June with his call for a referendum, prompting the European Central Bank to cap how much Greek lenders could borrow – that gives creditors the most leverage over Greece.

To review: the bank closures in Greece have sent the economy reeling, firms are closing at an accelerated rate, and Greek banks are at risk of insolvency. The banks have just reopened, but they’re still desperate for cash.

If the banks are not recapitalized soon, they’ll sharply curtail lending, and economic activity will fall precipitously. Greece would be forced out of the eurozone and would have to adopt a new, devalued currency. Greeks would find euro-denominated debts to foreigners more difficult to repay, and many would default. The defaults would delay the return to growth because foreign lenders would be even more reluctant to extend credit in the future.

Key to the new political calculus is Greece’s inability to recapitalize its own banks. Because it is so deeply in debt, the Greek government has no financial resources to spare. It is already behind in paying regular expenses. And the Greek central bank gave up the power to recapitalize the banks by printing new money when Greece joined the euro.

To recapitalize its banks and avoid economic implosion, Greece needs an immediate infusion of foreign funds. This gives Europe unprecedented leverage to help Greece help itself. By making current aid depend on immediate reform, Europe changes the calculus for Greek lawmakers when voting on reform proposals: it increases the payoff to voting Yes, because it helps Greek voters avoid a deeper banking crisis, and it reduces the costs to voting Yes, because the eurozone itself will take some of the political heat.

What’s in it for the eurozone? Its leaders would prefer to avoid the uncertainties and precedents of a Grexit. And in the long run a stronger Greek economy will import more of their products, supporting economic growth throughout the region. And, of course, a stronger Greek economy will need less debt relief; who can complain about that?

What’s with the IMF?

Another puzzle: why would the IMF acquiesce to the current agreement if it believes debt relief is critical? Keep in mind that the IMF wants to maximize its chances of being paid back. Those chances rise whenever Greece implements reforms, because they strengthen the economy.

The IMF could also benefit indirectly from reforms because they might alleviate the political opposition to debt relief. Forgiveness from other institutions frees up resources in Greece that can be used to pay back the IMF.

In short, another incentive for not insisting on immediate debt relief could be that waiting is required to make reform happen, and reform is politically necessary for actual debt relief to occur down the road.

Clues that debt relief lies ahead

If the Eurozone creditor governments do have in mind a long-run plan that includes significant debt relief, they clearly cannot openly discuss it today.

Nonetheless, their close cousins in the European Commission called this week for just that: an eventual “reprofiling” of Greece’s debt conditional on “a far-reaching and credible reform program.” Reprofiling amounts to implicit debt forgiveness through the lengthening of maturities, deferring of interest and similar adjustments.

The eurozone plan itself hints at this possibility. The first sentence highlights the importance of rebuilding trust. Specific reform proposals target the perception of unfairness, stressing that Greece should match policy standards elsewhere in Europe. For example, “labor market policies should be aligned with international and European best practices.”

And tucked in at the end is a brief but explicit hint of possible future forgiveness:

Against this background, in the context of a possible future [European Stability Mechanisms] programme … the eurogroup stands ready to consider, if necessary, possible additional measures (possible longer grace and payment periods) aiming at ensuring that gross financing needs remain at a sustainable level.

Of course, this vague gesture toward forgiveness is immediately linked to the necessity of reform: “These measures will be conditional upon full implementation of the measures to be agreed in a possible new programme.”

So Greeks and others who think the Germans are being a little harsh with their demands for austerity without debt relief should take heart. Good things may ultimately come to those who wait – and endure.

Carol Osler does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.