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How Greece and Europe can both win

How Greece and Europe can both win

The press is making much of the academic qualifications of Greece's new finance minister, Yanis Varoufakis. His specialisation is economic game theory, which in this case might be described as 'the art of bargaining'. Good bargaining skills are, indeed, important. But there are also some basic realities that can't be altered by the skill of the bargainers.

The first of these is that Greece has more official debt than it can ever hope to pay back (175% of GDP). But there is no realistic prospect that this debt can be written off (or even written down to a manageable figure) in the current negotiations. The second basic fact is that all parties to the negotiation would rather Greece continue as part of the euro, because 'Grexit' would be a disruptive mess.

These basic realities should define the logic of the negotiation. First, the repayment should be pushed even further into the future and the interest burden should be trimmed. Second, there has to be a continuation of 'conditionality', the reform requirements that keep Greece's 'feet to the fire'. But this has to be calibrated to the needs of economic growth, not as a punishment for debt recalcitrance.

To settle the details around these basic realities and the semantics of any agreement, a bargaining 'game of chicken' is underway. This is where game theory might be relevant. The negotiator who is most willing to go to the edge is likely to get the best deal on the details. But there is a chance that he will take the negotiations over the edge, leaving him with the blame for ending up where no one wants to go. [fold]

Politics provides the dynamic energy for this game of chicken. New Greek Prime Minister Alexis Tsipras has promised his electorate that he would get a fundamental resolution of the debt, not a simple extension. He promised, too, that the fiscal stranglehold will be eased. 

The current negotiations might be seen as the preliminary rounds, with each contestant feeling the other side out for weaknesses. But at some stage soon both sides need to acknowledge that there is room for a satisfactory outcome short of Grexit.

The Greeks need to understand that they can't take the terms of their electoral victory as the immutable basis for renegotiation. One of the required skills of successful politicians is knowing how to get away with breaking electoral promises. For their part, those European countries (like Norway Finland) that focus on the sanctity of debt should understand that this debt is not worth anything like its face value. If the negotiations do go over the edge, the creditors won't get much back. 

When the parties get down to the detail, they will find numerous embellishments which both sides can count as 'wins'. 

First, the debt extension. Even though there is no chance of a definitive solution, several important improvements could be made. The interest burden could be trimmed (it is already quite manageable, at around 2% of GDP). This might best be done by the Europeans taking over the IMF share of the debt, replacing it with the cheaper lending which the European Financial Stability Facility provides. This would make amends for the way the Europeans conned and ramrodded the Fund into providing its share (12% of total debt) in the 2010 rescue, totally contrary to the Fund's sensible principle that it shouldn't lend when there is no good prospect of being repaid. And when the debt is written off at some later stage, it will also address the awkward fact that another sound IMF principle will have been transgressed: that the Fund's lending, provided in the midst of a crisis, should have priority over all other creditors.

It would also have a big cosmetic presentation benefit for the Greeks: the overbearing troika (IMF, European Central Bank and European Commission) would be disbanded, to be replaced by a single task-master.

How tough should the reform conditionality be? The current debate needs to be shifted to a more realistic level. A healthy and growing Greek economy would be the best outcome not just for the Greeks, but for the other Europeans who will get more back when the debt eventually comes to be trimmed to a manageable size. 

So the central question is: what fiscal stance will maximise Greek growth over the next decade or so? There will be no clear-cut answer, but at least we won't waste too much time wishing that the Greeks were as stoic as the Latvians, who cut their budget deficit by 8% of GDP in a single year. There will be many detailed instances where the external pressure will actually help the Greek administration do the things it knows it has to do, but which are fiercely opposed by domestic vested interests.

When it comes time to package whatever agreement is reached, a pretty good story can be told of the Greek reform process (see these six graphs). The missing part of the narrative so far is an economic recovery. The Greek basic budget (ie. excluding interest) is now in surplus thanks to painful cuts. Now to get on with the harder structural reforms, such as selling some government assets.

Photo courtesy of Flickr user Day Donaldson.

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