Who Just Blinked? Hard to Say

So, Varoufakis finally met with the two people who really matter – ECB Chief Mario Draghi and German Finance Minister Wolfgang Schäuble – and to all outward appearances it blew up in his face. He left the meeting with Draghi in good spirits, telling everyone they’d had a meaningful converation, only for the ECB to turn around and tighten the leash just in time for the meeting with Schäuble to start, leading to much head-scratching.

Alright, two questions then. First, "tighten the leash" how? By stopping recognition of Greek bonds as legitimate collateral for ECB loans. The ECB claims that is was rule-bound to do that. Actually, it’s not really – what it accepts as collateral is largely up to it. However, it’s true that it wouldn’t accept Greece’s junk-rated bonds under normal circumstances. It was only agreeing to accept them under the Troika scheme, whereby Greece agreed to implement certain fiscal reforms in exchange for bailouts and various loans. The last of these (bailouts) was to be delivered by the end of February, already under an extension to give Greece more time to comply, but the new Syriza government kicked out the Troika inspectors. So, the ECB can plausibly argue that it’s legally bound to do this: after all, Greece unilaterally terminated the agreement under which it was accepting their bonds as collateral in the first place. What it can’t plausibly claim is that it’s actually legally allowed to be a member of the Troika at all, because it’s not under EU rules. And yet there it is. It’s also important to note that this does’t cut off Greece’s liquidity supply. Greece can still borrow from the ECB, it just has to do it through its own central bank. So, the Greek Central Bank borrows money from the ECB which it then lends to Greece in exchange, one presumes, for those same junk bonds that the ECB won’t accept anymore. This is "tightening the leash" in that it takes place under a formerly-secret-ish program called ELA (Emergency Liquidity Assistance) with two important consequences: the interest rate the Greek government pays will rise substantially (from 0.5% to 1.1%-ish), and this program is reviewed every two weeks. So, the ECB is basically signalling to Greece that it can cut off funding at any moment if it steps out of line.

Second, "tighten the leash" why? And why now? That’s the part that doesn’t make sense.

If you look at this from a fiscal perspective, you would say something like this: that the ECB was only accepting Greek junk bonds as collateral under faith that Greece’s participation in the Troika program would eventually make them worth a damn. A normal investor can’t credit them because he doesn’t have policy oversight over Greece. The ECB does, at least temporarily (albeit of dubious legal status), so Greek bonds should in theory be worth more to the ECB than they are to everyone else. So far so good. Thing is, nothing’s really changed about any of that. Varoufakis had just left a meeting with the ECB – so the ECB would apparently still have more control over the value of Greek bonds than anyone else. And exercising that control by forcing Greece onto ELA can’t actually help their value. This just (a) makes Greece’s debt service more expensive at a time when it needs to get cheaper (b) introduces pointless uncertainty into Greek finances, which is bound to spook Greek depositors, leading to still more capital flight, which will either lead to (c) more borrowing by Greece’s Central Bank from the ECB which in theory increases EU exposure to the whole ordeal right at a time when EU exposure was dropping and at the same time (d) increasing the risk that Greece exits the Euro, which is the same thing as burning all those Greek junk bonds that you were invested in propping up. Nothing good seems likely to come of it.

If you look at this from a political perspective, it doesn’t seem any better. It’s true that there’s something to be said for putting the new Greek government in its place. They were antagonizing people needlessly by doing showy things like visiting Nazi resistance memorials, kicking out the Troika, and drumming up dissent among Southern European leaders (albeit with little visible success). But that stuff is mostly just show. When you look at substance, Syriza has been doing what it can to signal to Europe its willingness to cooperate as much as it can without breaking up the party. It HAS to put on a macho show for the crowd back home, but out of the other side of its mouth it’s been saying everything the EU wants to hear: no default, no haircuts, will continue to run a primary surplus, will push ahead with tax reforms. It’s haggling over details, not fundamentals. Why, exactly, would you need to bring a party like that to toe? Answer: you don’t, and in fact you shouldn’t, because if you put it in its place too forcefully it will either (a) revert to its origins and start acting like the crazy Chavistas that form its back benches or (b) collapse, resulting in another election with probably even worse results than this one. So again, nothing good seems to come of it.

So why do it?

I can think of three reasons.

First, you may have noticed that in the "fiscal" paragraph I cheated a little by assuming that Greek banks would end up having to borrow more, thus increasing EU exposure. In reality, that’s just a possible outcome that only happens if the ECB plays along. The increased discretion of ELA means that the ECB reviews this every two weeks now rather than every two months. So it puts Greece on a much shorter time table. That only increases EU exposure to Greece’s problems to the extent Greece continues to comply with … whatever it is the ECB wants. So, it’s less of a problem than it seems. If Greece steps out of line, exposure abruptly ceases. Really, it’s just the ECB signaling to the world that it’s taking a more diligent approach to Greece – it replaces Troika oversight with more timely reviews. You could, if you were so inclined, read that as the ECB saying "OK, go ahead, no more Troika, we agree – but we have to tell everyone you’re staying the course somehow, so this is how." In other words, it trades Greece(‘s government) some flexibility in how it implements reforms in return for more micro-authority over how much Greece can borrow. Seen that way, it’s probably exactly what Syriza wanted.

Second, it might be some kind of Schelling maneuver, as suggested here. The link notes that the switch to ELA was announced between meetings – i.e. after the ECB meeting and ahead of the one with Schäuble. It hypothesizes that it’s meant to strengthen Greece’s hand by giving it fewer bargaining chips. That’s a concept that, for whatever reason, is enjoying a bit of renaissance in popular media these days – but it’s essentially the logic of Mutually Assured Destruction from the Cold War days. By convincing – and I mean really convincing – an opponent you have nothing to lose, you can make him more pliable in negotiations – with the key insight being that sometimes convincing someone that you have nothing more to lose involves preemptively giving things up. Like Cortez burning his ships ahead of the invasion of Mexico (not just telling but showing your men that retreat isn’t an option has a way of motivating them to fight harder). So, Mr. Coppola is speculating that the ECB was doing this to strengthen Varoufakis’ position against Schäuble by giving him less to give away. If the only trump Mr. Varoufakis has left is a Euro exit, Schäuble would have to negotiate in better faith than he otherwise would … seems to be the logic.

Third, it might be a sinister plot to keep Greece in the Euro indefinitely at minimal cost – as argued here. The idea there is that the ECB will continue lending Greece just enough to prevent a bank run, but not so much that it can do anything but cut spending. So, it would stay in the Euro, because leaving would be more expensive, but it won’t be able to diverge from austerity because the resources just won’t be there. Let’s call this the Vampire Scenario, because in that case Greece basically never grows again, just keeps not defaulting. The only objective there is to prevent contagion: the EU gives up on ever really getting its money back in any meaningful sense, but it at least prevents the problem from spreading (either politically, in the form of a Euro exist precedent getting set, or financially, in the form of non-performing loans causing another run).

I’m terrible at predicting these things, but I’m gonna bet on the first. The second is too clever by half. I can’t really see the ECB "sabotaging" Varoufakis in order to back him being the kind of thing that happens outside of textbooks. And anyway, it doesn’t seem to have worked: Schäuble didn’t end up making any meaningful concessions, at least not in this first meeting. The third is just crazy. The ECB/EU can’t possibly think that letting Greece languish on at 28% unemployment in a continuing demand crisis can do anyone any good in any way. If nothing else, it just makes the EU look really, really bad. But more importantly, why do it that way when you can do it the other way? Why make Greece suffer to prevent an EU-wide bank run when you can let it grow a little instead and achieve the same result? It just doesn’t make any sense.

Of course, it’s always possible that Europe is just being stupid. It’s entirely possible that this whole mess is yet another example of German cultural psychology causing problems for its neighbors. Germany’s so stuck in a "debts must be repaid and contracts must be kept" mentality that it can’t be flexible, with the result that Europe can’t be flexible, with the result that it can’t respond appropriately.

So, I choose to believe that it has, in fact, responded appropriately. Putting Greece on ELA instead of accepting its bonds as collateral directly is what I said in (1) – a kind of back-handed vote of confidence in Greece’s new government. It acknowledges and accepts Greece’s request (made in the form of a demand) for more autonomy in fixing its problems, but only in exchange for a more abrupt mechanism of pulling the rug out from under it if things go wrong. This won’t be the best analogy I could have thought of, but it’s a bit like handing your teenager the keys to the car and turning off all your GPS oversight apps in exchange for the teenager agreeing to take over car payments. It’s still your credit that takes the hit if he starts missing payments, but the hope is that by giving him more responsibility and autonomy, he has a stake in working things out.

And how did it work out? Too early to tell, but so far there has, in fact, been some capital flight, and some market signals of waning confidence in Greece, and at the same time some signals of more responsibility coming from Syriza: they’ve agreed to reconsider privatizing state industries. In concrete terms, they will not, contra some previous declarations, be shutting down the office of consultants that looks into that, and they’ve made some signals to the effect that they might be willing to privatize some utilities, but they’re not making any firm promises yet. So, a bit like coming home to find job applications in the teenager from the previous paragraph’s tortured analogy’s bedroom. It’s not quite a plan to make car payments, but it at least shows he’s taking it seriously.

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