Geographies in Depth

How to make the Greece deal work

Lucrezia Reichlin
Professor of Economics, London Business School
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Greece and its creditors are now enacting a deal that provides financial support in exchange for wide-ranging reforms. Although reservations about the agreement abound, political conditions did not permit a better one. But the deal can – and must – serve as the basis for saving Greece and the eurozone.

For the plan to work, Greek Prime Minister Alexis Tsipras must show real commitment to a reform program in which neither he nor many Greek citizens believe. And he must forge an alliance with Greece’s pro-European parties, because only a united government will be able to deliver.

The creditors must find the money to fund the bailout. And the International Monetary Fund must agree with the Eurogroup on how to restore debt sustainability in Greece, a precondition for the country to regain access to capital markets.

In this effort, a critical distinction must be made: though Greece has committed to deep and rapid reform, it must not be forced into hurried fiscal consolidation. Indeed, such an approach could undermine urgently needed structural reforms, not least by destroying the political capital required to enact them.

Unfortunately, the recent agreement includes unrealistic proposals for fiscal adjustment. Before Greek banks closed and capital controls were imposed in late June, the European Commission put the primary budget deficit for this year at €4-6 billion ($4.3-6.5 billion), or 2-3% of GDP. Now, it looks like the primary deficit (which excludes interest payments) could reach 6% of GDP, with GDP falling by 4%.

Yet the new deal anticipates that Greece will make up for the year’s fiscal shortfall in just five months. As Greece and other eurozone countries have already learned, attempting to rush fiscal adjustment increases the debt burden, as the liquidity squeeze and concomitant uncertainty undermine output and reform efforts.

For example, one of the key initiatives to address the fiscal shortfall is an increase in the value-added tax to 23% for almost all goods and services. But with VAT evasion in Greece as high as 50%, the hike will place firms that pay, which tend to be larger and more efficient, at an even greater disadvantage relative to firms that do not. Greece should therefore focus first on building the legal and technical infrastructure to combat tax evasion.

Greece’s government will find it hard to adhere to the new program unless its fiscal targets make sense. Though it is politically unrealistic to renegotiate the deal at this point, a serious analysis of the necessary fiscal adjustment, possibly arbitrated by independent experts, is needed.

The IMF’s latest analysis of Greece’s debt sustainability reinforces this assessment. Despite pressure from Germany and other countries to participate in the new bailout program, the Fund will not get involved unless it judges Greece’s debt to be sustainable. That means making the economy’s debt stocks and fiscal flows consistent, with the right combination of tough but feasible fiscal targets and debt relief.

Fiscal discipline should not take priority over the important structural reforms included in the new deal, particularly measures to overhaul pensions, the legal system, product markets, public administration, and the judiciary. Implementation will be very difficult even without excessively tight fiscal targets; with them, it may be impossible.

Previous attempts at pension reform, for example, have been partial and indecisive, with exceptions and grace periods undermining their effectiveness. Similarly, though attempts to reform the code of civil procedure, aimed at improving the judicial system’s efficiency, began in 2011, little progress has been made, owing largely to the government’s failure to face down opposition from lawyers’ associations, which stand to lose their excessive fees from useless procedures. And, although the groundwork has been laid for product-market reforms, no preparations for serious public-administration reform have been made.

The key to overcoming these challenges is for the Greek people to take ownership of the reforms, so that the public interest can prevail over vested interests. But that, too, will be difficult, given the widespread view that the reforms are being imposed on Greece by its creditors. Tsipras must lead the way by building a broad consensus.

The details of the reform legislation are important. Rather than attempting to meet unfeasible deadlines, legislators should proceed with deliberate speed.

Meanwhile, Greek banks – which, given their huge volume of non-performing loans, are now more likely to be insolvent than illiquid – will require massive recapitalization, funded by the European Stability Mechanism, not the Greek state, in order to break the bank-sovereign link. The operation might involve restructuring as well.

In this effort, there must be no bail-in of depositors, which would have damaging social consequences, or Greek state ownership of the banks, which would entrench clientelism in the financial system. The ESM would later sell the banks in open auctions to recoup its investment.

Many in Greece, as well as some outsiders, have called the new agreement “neocolonialist oppression.” And, indeed, Greece’s humiliation in the negotiations evoked memories of the Indonesian president’s treatment by the IMF during the Asian financial crisis of 1997. (Some creditors feel that they are the true victims, exploited by Greek counterparts who never intended to fulfill their promises.)

But the Greeks must put aside these emotional responses and recognize the need for many of the proposed reforms. Greece’s failure to implement them has allowed the clientelism, oligarchy, corruption, and tax evasion underpinning its economic and political dysfunction to continue practically unfettered.

The alternative is a Greek exit from the eurozone. (German Finance Minister Wolfgang Schäuble’s suggestion that Greece can just take a “time out” is a fiction.) Economists who pretend that this would be anything less than an economic and political catastrophe for Greece should look closely at the structure of Greek trade, the anemic response of exports to the already huge internal devaluation, and company and household balance sheets.

Some would welcome the damage this would do to European unity; we would not. The recent agreement is far from ideal. But Greece and its creditors must make it work.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Authors: Lucrezia Reichlin, a former director of research at the ECB, is Professor of Economics at the London Business School. Elias Papaioannou is Professor of Economics at the London Business School. Richard Portes is Professor of Economics at London Business School and President of the Centre for Economic Policy Research.

Image: A European Union flag (L) flutters next to a Greek flag on the facade of the Bank of Greece headquarters in Athens April 14, 2015. REUTERS/Alkis Konstantinidis.

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