Early news reports seem to be pretty clear that Syriza has won the Greek elections, so I thought CT readers might be interested in the following note, which I sent to my professionals’ mailing list a few weeks ago. Since I wrote it, there has been a lot of rather contradictory comment on what the party’s negotiation strategy might actually be, but nevertheless, it certainly seems that the “ultimatum” approach to debt reduction is very much on the table, and in any case, a dogmatic refusal to continue with past agreements on structural measures would end up having the same effect.
GREEK GAMES AND SCENARIOS
In the last issue in this series, I made a few predictions around the general theme of my prediction that the resolution of the European stress tests would remove a significant supply constraint and lead to credit growth in 2015e that would surprise everyone. Specifically I was looking for a) large takeup of the second tranche of TLTRO, b) a step jump up in measures of bank sector risk appetite and c) strong lending growth starting Q1 15e. I count that so far one loss, one win and one yet to be decided. The sector is so awash with cheap funding anyway that TLTRO excess was hardly needed (and the carry trade is unprofitable given higher capital charges and lower yields on government debt), so it was always a bit of a daft idea to make that a success criterion. But the risk appetite measures and lending surveys are all going in the right direction. So I am still broadly happy to be predicting a strong credit recovery for Euroland in 2015e.
But the clear risk to that forecast is another go-around with a sovereign Eurocrisis like we had in 2011-13. And in turn, the clear risk of that is that Syriza wins the election early in 2015 and starts on the program of “create a load of chaos in Euroland in order to get concessions” which it has been indicating (and occasionally and rather scandalously, pretending that it isn’t). So it’s worth wargaming out what the various parties might be thinking and how their strategies might interact.
One thing it’s important to make clear is that the European policy makers aren’t stupid. I have lost count of the number of articles I’ve read where some opinion columnist or other acts as if the fact that Greece’s debt burden is unsustainable and cannot ever be repaid is some special insight available only to readers of his newspaper, and that the benighted fools of the Commission, ECB and Eurogroup are so ideologically blinkered that they can’t see this obvious fact. Often enough, this piece of pontificating is attached to some distinctly dodgy theorising about the peculiar national characteristics of “Germans”.
The fact is, everyone knows that the total burden of Greek debt is too big to be serviced by the Greek GDP, and that if it isn’t written down, then Greece will always be reliant on an increasing stream of official financing to meet its roll-overs. Everyone also knows, although some of them might not be ready to admit it to themselves, that an indefinite commitment to financing the roll-over of an ever increasing debt burden is a fiscal transfer in all but name. The thing is, though, while the Eurosystem bureaucrats know this at least as well as anyone else, they have jobs in which they can’t simply bemoan the fact in print, then submit their copy and go off to think about something else.
Don’t think of the Greek debt burden, either in cash € terms or as a ratio to GDP, as an economic quantity. It basically isn’t an economically meaningful number any more. The purpose of its existence is as a political quantity; it’s part of the means by which control is exercised over the Greek budget by the Eurosystem. The regular rituals of renegotiation of the bailout package, financing of debt maturity peaks and so on, are the way in which the solvent Euroland nations exercise the kind of political control that they feel they need to have if they are going to be fiscally responsible for the bills. There’s more than a couple of Germans I’ve spoken to over the last few years who have pointed out that although Germany got massive debt relief in the twentieth century, it got it in the context of an equally massive national admission that the entire political system was rotten and needed to be totally restructured with foreign help; this was also the basis on which the integration of Eastern Germany was managed in the 1990s. Seeing the peripheral Eurozone debt in isolation from the politics of European integration is a sure way to lead yourself up blind alleys.
It is, therefore, totally inimical to the Eurosystem to hold out any hope of the kind of debt writedown that Syriza wants, as opposed to some smaller, cosmetic face value reduction or maturity extension. The entire reason why Syriza wants to get a major up-front reduction in the debt number is to create political space to execute the rest of their program. The debt issue and the political issue are the same issue. Syriza understands this, and so does the Eurosystem. The people who don’t understand it are the ones writing editorials in the business press which support the debt reduction but don’t think that Syriza should be given carte blanche to do everything it wants.
So, the question is – does Syriza have any way of getting itself into a position where it can make the Eurosystem do something that they really, really don’t want to do? It’s not that hard to see what Tsipras’ line of reasoning is:
i. The Eurosystem bureaucracy’s entire reason for existing is to ensure the continued existence of the Euro.
ii. If Greece leaves the Euro it will cause a financial crisis in Euroland
iii .A financial crisis in Euroland would immediately spread to Spain and thence to Italy
iv. In the event of a financial crisis in Spain and Italy, the Eurosystem would be at real risk of seeing the currency break up, and would have to agree massive and immediate fiscal measures to prevent this
v. So, present them with a fait accompli on the debt default, and gamble that they will not have the nerve to take measures which might have the effect of forcing Greece out of the Euro
vi. Specifically, default and then finance the deficit by selling short-term Treasury bills to the banking system, who will finance them at the ECB
vii. This effectively puts the ECB in the position of having to either cut liquidity provision to the Greek banking system (which triggers Greek euro exit), or to effectively finance the Greek deficit.
viii. In this doubly intolerable situation, you can presume that the ECB will preserve its own position by forcing the rest of the Eurosystem bureaucracy to come up with a fiscal solution that doesn’t involve the ECB.
ix. And Greece is small enough that it is always going to be less trouble to finance their problems than to deal with the consequences of not doing so.
As a strategy it is …cute. I think it might even have worked if tried three years ago; as far as I can tell, something like it was the unspoken threat under the table which led to the restructuring of the Irish bailout liability. You can see that it’s a blackmail game that is best played by a left-wing populist, because in order for the threat to be credible, it needs to be made by someone who is not susceptible to apocalyptic warnings and who is even prepared to dice with the prospect of actual bank runs. I can entirely see why it’s attractive to Syriza and why Tsipras has made it a constant theme of his recent rhetoric that Greece is in a stronger negotiating position than it realises.
But this isn’t three years ago, and I think that if faced with this sort of behaviour by a Syriza government, the ECB would definitely decide to call the bluff. Reason basically being that a huge amount of work has been done precisely to reduce the dangers of this sort of contagion:
i. The ECB is now lead supervisor for any bank in Euroland which it wants to be. Greece couldn’t simply rely on the local banks to take up the T-Bill roll.
ii. The rules on liquidity provision have been tightened up significantly since the days in which the Central Bank of Ireland was able to effectively act as lender of last resort and then tell Frankfurt what it had done later.
iii. Most importantly, banking sector collapses are much less frightening to the Eurosystem bureaucrats than they used to be.
That last point could probably do with a bit of amplification.
Here’s something which struck me when I was putting together an end of year review of developments in bank regulation. Euroland had a real, credible stress test and it wasn’t the one that we were all looking at. The real stress test in 2014 was the restructuring of Banco Espirito Santo.
What do I mean? Well, the key to understanding stress tests, as I’ve been saying for years, is to remember that they’re not a test of the banking system; they’re a test of the bailout system. The purpose of a stress test isn’t to bore the pants off us with megabytes of accounting data telling us things we already knew. The purpose is always to put the weakest banks in the system into a position where they need to be recapitalised, and thereby to demonstrate that the system is capable of dealing with capital shortages, and doing so without an unreasonable fiscal burden.
The AQR didn’t really do that – it was a perfectly good exercise of its type, and as I wrote in October, it performed admirably in giving a regulatory “seal of approval” to the solvent banks, but it didn’t really generate any self-inflicted crises, so it wasn’t able to demonstrate that the Euroland Banking Union was capable of dealing with crises.
On the other hand, the quick and brutal treatment of BES demonstrated that even in a comparatively large European bank, and even in one of peripheral Europe’s shakiest fiscal systems, it was possible to carry out a refinancing and resolution over a weekend, with legal certainty and without contagion to other banks or interruption of vital services. That’s the stress test which matters.
The successful outcome from BES must surely encourage the Eurosystem policy makers to think that Greek euro exit, if it happens, could be contained. It’s no longer all that likely that any Euroland bank has big enough Greek exposure to knock over its capital, and even if there is a genuine liquidity squeeze, the ECB can pour out liquidity support much more aggressively than it did in 2011, because it knows that its own balance sheet risk is small. In 2011, the ESCB’s unsecured funding was at risk of loss, because in the event of insolvency it would be just another unsecured creditor in most European legal systems. In 2015, the new structures of the Bank Resolution and Recovery Directive means that the ECB, along with all other short term and interbank creditors, get to effectively jump the priority structure by putting banks into BES-style resolution, making themselves safe by hosing the long term creditors without ever letting them see the inside of a bankruptcy court.
So my guess is that Tsipras’ strategic chain described in section 4 above breaks own pretty early on – the ECB and the Eurosystem structure don’t think that he’s got a credible threat of being able to cause the kind of chaos that could lead to the Euro entirely breaking up. So game over? I think not because there are two further strategic wrinkles.
i.Although Greece can no longer destroy the whole Euro, they could certainly create a situation in which they end up being forced out themselves. This wouldn’t be disastrous, but it would be annoying for the Eurosystem bureaucrats. Their long term goal is, remember, for the Euro to cover as much of the EU as possible, and that goal has been going surprisingly well – in the last two years they’ve actually gained two members in Latvia and Lithuania. But if you lose Greece, my intuition is that you can forget about Poland. It’s worth remembering that the “ever closer union” is essentially an Empire-building project, and if you’re building an Empire, you don’t let yourself lose provinces just because they’re a pain in the neck.
ii.And given (i) above, it matters that Tsipras might not be aware that he is bluffing a pair of deuces. If he genuinely believes that the Eurosystem will give in, it is in his interests to create a situation in which Greece could end up being forced out of the Euro, even though this is an outcome that nobody actually wants.
iii.And of course, even if Tsipras understands that the game is up for the strategy in section 4, it’s in his interests to pretend otherwise.
So the situations worth considering are (in the event of a Syriza victory):
i. Syriza effectively crumbles. The radical version of their strategy, with doubling of the minimum wage etc, is given up on, in favour of some broad and face-saving qualitative adjustments to the program. There is no debt default, no meaningful face-value reduction and things continue much as they were in the status quo ante (which, recall, did actually have Greece getting back to growth).
ii. Syriza plays the “madman strategy” and Greece leaves the euro. This would be the mother of all buying opportunities, in my view, as it would surely be associated with a massive risk-off trade, but the market would be quick to subsequently realise that the actual effect on the Eurozone was heavily quarantined.
iii. Syriza plays the “madman strategy” and gets given meaningful concessions to keep it in the Euro. One would expect this to be associated with a lot of self-congratulation from the ECB and repetition of “whatever it takes” speeches, and the end result would be to either monetise or mutualise a load of the Greek debt burden. This would be very bullish too.
So my view is, I guess, that if you can close your eyes and open them again in January 2016, you buy Eurozone risk and hold it. How many of us are so lucky – not one in ten thousand I guess. So I would suppose that the best trading strategy would be to keep some powder dry. It should be noted in that context though that the risk in Greece is much more quarantined than people necessarily realise. So non-Greek peripheral credit looks like it could be cheap, and potentially a way of parking cash somewhere without equity downside but some share in the upside when things get resolved and the market snaps back.