Brinksmanship and Grexit

Henry Farrell re-ups his view of the eurozone as being a game of brinksmanship between Germany and Greece. I objected to this characterization back in February, and I still don't think it's the best. Take this:

If there weren’t any possible resolution, there wouldn’t be any incentive to engage in crisis bargaining. What we’re seeing suggests that the players on both sides think that there is a real chance of catastrophe, but also a real chance of a deal.

Whether or not there is a possible resolution is most likely private information. (Or, more accurately, neither side knows the truth.) Let's look at this from Germany's perspective. Who are they negotiating with? For all intents and purposes Greece does not have a government that is capable of negotiating. Any future Greek government also has an inability to make a credible commitment to uphold any negotiated settlement in the future, which is why Germany had previously asked for all political parties in Greece -- whether in the government or not -- to approve of the previous bailout program. It is not clear right now who "Greece" is, much less what it is willing to accept.

Nor is it necessarily clear (to me) that Germany believes that there is a real chance of catastrophe for them if Greece exits. Perhaps there is, but it's probably not an economic catastrophe. At this point it might be cheaper to shore up the banks than to keep funding Greece indefinitely. Remember that Greece's creditors have already taken very large haircuts. Remember that European banks have had years to prepare for this, and European regulators have (presumably) been forcing them to do so. Euro governments, the ECB, and the EFSF would lose something on the order of €200bn from a full Greek default, of which €75bn would come from Germany. This is not nothing -- about 3% of Germany's GDP -- but it isn't enough to sink Germany either.

More likely Germany is worried about the political ramifications of a break-up of the eurozone, but in that case they should be interested in ensuring that they are not blamed when that happens. This implies that they will engage in negotiations right up until the end, and perhaps even after it, to demonstrate that they made a good faith effort to keep the monetary union intact even if they believe that there is no possible resolution that actually keeps the monetary union intact.

Farrell:

At a guess, Greece has considerably more bargaining leverage than it might seem to at first. One useful index of bargaining strength is relative levels of sensitivity to breakdown/catastrophe/failure to reach a deal. It’s plausible that Greece is relatively indifferent to breakdown at this point – years of grinding austerity inside EMU seem barely preferable to the costs of exiting the euro. In contrast, Germany could see the collapse of the euro (and consequent very serious economic costs) if a Greek exit leads to the collapse of confidence in Spanish, Irish, and worst of all, Italian banks. If I were to lay a bet on which side is likely to fold first, I’d be putting my money on the Germans.

Again, it's not clear who "Greece" is or what their bargaining position is. As Daniel Davies says in comments on Farrell's post, there is no reason to think that Greece is indifferent between staying in or getting out. Something like 80% of Greeks say that they want to stay in. Even Tsipras has stated no intention to exit. The best case scenario of leaving -- probably Argentina -- is not very good, and I wouldn't be optimistic about the best case scenario obtaining in this case. So how much leverage does that really give Greek leadership? If their citizens want to stay in, and the costs of leaving are extreme, then Germany can demand quite a lot.

Nor is it clear that a Greek exit would lead to a collapse in Spain, much less Italy, or that such a thing could be avoided even if Greece stays in. The fundamentals are crap either way. It's not clear that a collapse in these countries would be devastating for Germany. They've maintained economic growth thus far, and capital flight from the GIPSIs would likely move into Germany, giving them further fiscal flexibility to deal with their banks and macroeconomy.

Right now the political dynamic in Europe is about who gets the blame for a Greek exit. If blame cannot be assigned in a politically satisfying way then they will continue to muddle through. However the greater the costs associated with keeping Greece in, the more likely the blame will shift away from Germany and the more likely that Germany will refuse to pay on any terms that are acceptable to Greek leaders.

Edward Hugh writes of the choices:

Right now there are two, and only two, options on the table: help Greece with an orderly exit from the Euro (and crystallise the losses in Berlin, Washington, etc), or print money at the ECB to send a monthly paycheck to all those Greek unemployed. This latter suggestion may seem ridiculous (then go for the former), but so is talk of printing to fuel inflation in Germany (go tell that old wives tale to the marines). If Greece isn’t allowed to devalue, then some device must be found to subsidise Greek labour costs and encourage inbound investment – and remember, given the reputational damage inflicted on the country this is going to be hard, very hard, work.

The second of those is not palatable. It would wreck what remains of the political integrity of the Euro project, which has already been corrupted by the less-than-democratic approach to the bailout. Political integrity is not about keeping Greece in on whatever terms... moral hazard is a real risk and the original institutions designed to combat moral hazard (eg Stability and Growth Pact) have been obliterated as has the independence of the ECB. In other words, it's not clear what political integrity Germany would really be fighting for. The entire EU social contract has to be re-written anyway, at least implicitly.

Given that, Germany may wish to re-write it on more stable terms.

There is a very real chance that over a medium term time horizon Germany would be better off with Greece out of the eurozone. If that's the case then this isn't a brinksmanship game.