German proposal for Greece’s compliance: accelerating eurozone exit

At the top of my list of to do’s for the past few weeks has been to update the post on Greek PSI that I wrote just before Christmas to include some more recent developments, such as the prospect of ECB participation. Last night, Peter Spiegel from the Financial Times (@SpiegelPeter) published the German government’s proposal for Greece’s “improvement of compliance” with the terms of the bailout, and all of a sudden Greek PSI positively pales in comparison. According to Germany’s proposal, whatever the result of the PSI deal, Greece will need to “legally commit itself to giving absolute priority to future debt service” and “accept shifting budgetary sovereignty to the European level”. If the Greek government is not willing to do this, the troika would presumably turn off the taps of bailout money and Greece would default. With no access to market or official financing, Greece would be forced to exit the eurozone.

Germany’s proposal for Greece caught most by surprise, but we shouldn’t be so shocked by it. The ruling German Christian Democrat party (CDU) already published this idea in its November 2011 proposal for “A Strong Europe—A Bright Future for Germany”. According to this proposal, if a country is unable to meet its debt obligations, “the European Commission should provide the affected eurozone country with a commissioner responsible for budgetary savings, who would oversee the use of budgetary funds and the implementation of any restructuring measures that may be required.” The CDU goes on to propose that a clause should be created in the Lisbon Treaty to allow a country to voluntarily withdraw from the eurozone without exiting the EU.

This clause for a voluntary eurozone exit increasingly seems like a preview for things to come in Greece. Greece is currently in the midst of negotiating a PSI deal, without which it faces a hard default when it must roll over €14.5bn in debt on March 20th. There are only around 45 business days left before this deadline, an extremely tight schedule even without the huge distraction of Greece fighting for its fiscal sovereignty. The best case scenario is that a PSI agreement is reached, but will that really make a difference? If the Greek government does not sign up to the German proposal and Germany does not back down, a hard default by Greece is still likely.

Is the Greek government likely to agree to transfer its fiscal sovereignty to Brussels? Some Greeks have argued that the population would be better off if Greece’s fiscal discipline were in the hands of Eurocrats rather than corrupt Greek politicians. I think it highly unlikely a bureaucrat chosen by the Eurogroup would have more success changing the political culture and Greek attitudes towards corruption, wasteful spending or tax evasion any better than the Greek government can. Regardless, the Greek government has so far indicated it is dead set against the idea. When asked about the German proposal, one Greek government source responded “there is no way we could accept such a thing.” The government released an official statement saying responsibility for fiscal policy rests solely with Greece.

If the Greek government rejects the German proposal and the troika refuses to transfer any more tranches of funds to Greece, Greece will default. Without any access to market or official funding and running a primary deficit, Greece would be forced to abandon the common currency and reissue the drachma for the government to carry out basic public services and continue to pay civil servants. Greece would also be forced to exit the eurozone in order to regain competitiveness and return to growth.

I have long thought that the troika would cut Greece loose and let it default and exit the eurozone once eurozone banks had been sufficiently firewalled. Perhaps this aggressive proposal by Germany is one of the unintended consequences of the ECB’s three year long term refinancing operation (LTRO). If eurozone banks have as much access to cheap, three-year ECB funding as their collateral allows, perhaps Germany and the troika have decided that eurozone banks can survive a Greek default. Greece is clearly insolvent and must leave the eurozone to eventually return to growth. The German proposal may have accelerated the inevitable.


For more details on the potential implications of the German proposal for Greece, please see this analysis by RGE.

31 Responses to German proposal for Greece’s compliance: accelerating eurozone exit

  1. AnxiousJimmy says:

    Excellent article.
    The Germans surely must realise the resentment this will cause in Greece? The demands are shocking. As if replacing the elected government wasn’t enough they now want control of the state’s economic power transferred to an outsider. If this was an African state the EU would be calling it a coup.

    • “If this was an African state the EU would be calling it a coup.”

      agree with your comment. However, having appointed (not elected) a Prime Minister is close to having a non-democratic regime in my ears too…

    • rightpaddock says:

      The government wasn’t replaced – if you read the Greek press you’ll find that the ‘guys calling the shots” are PASOK’s Veninzelos and ND’s Samaras,

      Papademos was ELECTED by the overwhelming majority of parliamentarians, to create a Grand Coalition unity government to manage a crisis. Such a coalition would never happen under a PASOK or ND leader because of the feudal culture of Greek politics.

  2. the best views and predictions that are based on reality i have read so far. I tend to agree that it is a matter of time until Greece defaults to its debt and returns to a new drachma. At the moment there seems to be an artificial ‘stability’ within the Greek government but when the news for a potential default arrives the social and political cohesion will be at stake. That negative event will be the one to initiate social mechanisms that will attempt to remove corrupted political and economic elites from the hierarchies of influence. (i hope at least)

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  4. Interesting article. Germany could first save and then ask for a greater fiscal integration. They are choosing the opposite and they might be right. It was clear since the very beginning that peripheral countries could not not reach competitive levels of core members. This is the reason why Cohesion and Structural Funds were established. However, those policies have proven to be ineffective in the long run, maybe because they activated only demand side effects. Now the only way Greece could gain competitiveness is through exechange rate devaluation, since fiscal consolidation is contractionary in the short run and inflationary pressures are not tolerated by ECB. That is, by exiting the EZ. The sooner the better…

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  6. Mark says:

    I live in Ireland and have been thinking about the possible referendum on the fiscal pact that will shortly be drawn up. While initially my reaction is one of rejection, on further thought, why would anyone in either Greece or Ireland want their gombeen politicians to continue to preside over them? In Ireland, we have a government who is still giving pay rises to public servants! Crazy stuff. At this stage I would roll out a red carpet for the Germans. It’s time for serious intervention…

    • If your elected leaders dont stand up for you do you think a Euro bureacrat will? Be very careful Germans not only want surrender of budget to a Bureucrat – that is essentially the taxes that you pay – but also an article that our taxes will go first and foremost, not in national defence, healthcare, or education but in debt repaying!
      In the end Greek budget run by a German will be 10% debt repaying, 10% Eurofighter and Leopard II and Frigate spending, 10% Siemens contracts and the rest as expenses for the operation of their new european colony.
      They bluntly propose the confiscation of our future tax revenues by themselves. No way this will get accepted. They have to propose nothing more that economic slavery forever in order to save some failed banks.

  7. Frances Coppola says:

    BBC’s Stephanie Flanders is saying that Greece may in fact be in primary surplus now. If this is true, then default is much more likely because the immediate cost for Greece would be much less (although they would have a banking crisis). Clause 1 of the proposal – which everyone is ignoring – would force into the Greek constitution a commitment to give priority to debt service over other government spending, which in effect would rule out default. It sounds to me as if the EU leadership, at any rate, think Flanders may be right.

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  9. PR Guy says:

    It looks like a deliberately engineered move to me. Bye Bye Greece. Look out Portugal. Who’s next.

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  11. Ken says:

    There’s a good reason for why the Germans want a Gauleiter. If you look at employment numbers and GDP numbers for Greece over the past 3 years, it rapidly becomes clear that the Greeks have done next to nothing to reduce public sector headcount or spending until the last 6 months. In the meantime the private sector has begun to implode. Some progress appears to have been made on raising tax revenue, but this appears to mainly come via potentially ill targeted land taxes. The problem with the present plan is that I just don’t see it working. The private sector has cut back investment (and who in their right mind is going to lend money or even bother investing in Greece today?) and the plan is to slash public sector spending, without ever really getting a stable economy.

    Having allowed this to become a European problem, the idiots are going out of their way to look tough. They should have shot Greece 18 months ago and said “lying fool politicians” and then sent the Greeks aid. Now if Greece goes, it looks likely that the rest of the periphery will go. However it ends it will cost the Germans north of E400 billion. Hopefully it will kill off the Eurofederalist liars as well.

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  15. London Banker says:

    First, Greece is no longer running a primary deficit. It turned the corner into a primary surplus in Q4 2011. As a result, any further borrowing goes solely to debt repayment. Perhaps this is why Germany is seeking a superpriority for debt repayment as a condition of further funding.

    Second, Greece can default without changing its currency. In fact, I see little rationale for leaving the euro following a default. Greece will not export more or borrow more in drachma than it can in euro. Indeed, it seems likely that Greece would lose export market share if its businesses were forced to reprice into a less liquid currency, and the bank run would intensify causing more instability. Certainly Greek civil servants and pensioners would rather receive euros to spend than risk an inflationary drachma.

    • Megan Greene says:

      According to the ministry of finance, Greece had a primary deficit of around €5.5bn at end-2011. This excludes around €6bn in arrears.

      In the event of default, Greece would either have to stop paying its civil servants or otherwise make drastic cuts in spending while rapidly boosting tax revenue to close this gap (which would result in severe social unrest), or it would be forced to exit the eurozone and reissue the drachma. Defaulting deals with the debt stock problem, but does nothing to address the greater competitiveness and growth issues in Greece. Leaving the EZ and reissuing the drachma would help with the latter.

      • Exactly. Leaving the EZ would immediatly imply a devaluation of national currency vis-a-vis euro. This would boost exports and eventually economic growth (i.e. see Italy post-1992, or Argentina post-2002). In addition, by re-adopting independent monetary policy, Greece could implement the right policy mix to overcome the crisis. As for defaulting, since about 90% of sovereign debt is issued under local law, domestic inflation – tolerated by central bank – could reduce the debt stock in real terms, by means of some sort of “financial repression” à la Reinhart and Rogoff.

  16. Santiago Fernández says:

    I agree with Megan that the real issue of Greece is the culture of tolerance to corruption. But I must agree with Germany. By giving aid, one removes the incentives for political reform. This is explained in the paper “The curse of aid” (Simeon Djankov, Jose G. Montalvo, Marta Reynal-Querol). Fighting corruption is hard, requires commitment and risk by the Greek population, and by giving aid, the incentives are removed. It is not about the Greeks being good or bad, they are human, they will do what make them feel better, and, if with the help of foreign aid, they can avoid the terrible incoveniences of fighting power, the will do.

    The problem of Greece is the political system. They seem to live in a duarchy: the present and past leaders of the socialist party and the conservative party have the same surname (Papandreus) because they belong to the same families! Of course, such a regime of inheritance of power can stand by exchange of favours, by having many people living directly or indirectly from it.

    The only way for Greece to become competitive is to make a complete political reform. A constitutional change.

    Greeks must take their collective responsabilities. They must see corruption with a different eye. Not as something of “others”. One cannot expect to have eurocrats or anyone else to solve their own problems.

    Unfortunately, it looks like Greeks (and Spaniards) live inside a deep reality denial. It looks like making others have pity of them the only idea to come forward.

  17. Santiago Fernández says:

    Also note that leaving the euro is extremely difficult. There are several reports on this subject, I am sure Megan and others already know. But let us recall why leaving the Euro is close to crazy. Here is a report by Willem Buiter and another note from Credit Suisse (taken from the Spanish blog Nada es Gratis).

    Short term issues:

    – Bank panic, massive funds withdrawal. At the moment of leaving the euro, the deposits will loose ~ 40 % of value. Therefore, even the slightest rumor of leaving the euro would cause withdrawl of euros.
    – No credits. In case of changing currency, credits under the Greek law would change to the new currency. So Greek banks issuing them would loose lot of money: they will receive less money that received. So if it is expected a currency change, all credit lines will be closed, destroying companies and jobs.
    – Banks go bankrupt. As they have assets (credits) in the new currency and debts against european banks in euros, they will go bankrupt.

    Long term issues:
    – Incentives for fighting corruption and improving the competitiveness of the Greek economy removed will compensate the advantage of currency devaluation.
    – Greeks will avoid using the new currency, to protect their savings against devaluations. Real Greek economy will continue working with euros.

    There is no other option. Greek politicians must understand that a constitutional reform that returns the creditability to a corrupt political system controlled by two or three families is necessary.

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  20. rightpaddock says:

    I wouldn’t assume that what a junior minister in the German government says or even writes constitutes a German red line. In 2010 Angela Merkel – the Chancellor – said Germany would never contribute to a Greek bail-out – but it did. They also said they would never allow the ECB to create vast amounts of fiat money – but it has, and its going to create a whole lot more.

    The Budget Commissioner proposal is noise to placate the German electorate when the ECB agrees to take a haircut on its share of Greek debt – just another political gesture.

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  23. SCE says:

    Thank you for your nice sharing. Great job, keep it up.
    The bailout money will not go to Greece but straight into the lender banks that Greece already owes money to. Greece should be allowed to leave the Euro and default, before the high-debt European countries demand billions more cash.

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  25. esulart says:

    If I could only remember who wrote the poem; 16th/17th century in ‘Imperial’ Spain. I remember ‘Don Dinero’ and ‘los intereses interesados.’ In spite of the influx of metals, i.e. silver and some gold, the debt crises persisted and the economy of Spain imploded, inflation in taxes and prices led to hunger (which became a motif in the literature.) The last option to large debts is not more borrowing. Only the banks and other financial institutions are likely to prosper; in effect, the same corporations whose practices ignited the ‘debt’ crisis. All these ‘solutions’ ignore the victim and praise the predator. Government and private finance created the ‘debt’, but will not take responsible action to remedy the suffering.

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