Greece: Surplus, stimulus and strategy

Dan Davies
Feb 2, 2015 · 7 min read

I hesitate to be giving Yanis Varoufakis any advice in what to do in his negotiations with the troika on renewing Greece’s bailout program — he is, after all, a professor of economics with a particular specialisation in game theory. But game theory has a couple of weaknesses. First, it tends to work best in situations like mobile phone spectrum auctions where you can be reasonably sure that all the other players are playing game theory too. And second, it will only give you the correct steer if you have made the right assumptions about the other guy’s objective function. If you don’t understand why the other side are making the decisions they are making, then games of double-bluff and stand-off are very dangerous indeed.

So in that spirit, a few thoughts about what is likely to be most important to the Commission, what is most important to Greece and (finally) a tentative suggestion that there is a good compromise which can be reached which is favourable to both sides, but which doesn’t really look all that much like the kind of things that Syriza was talking about on the election trail. We get there via a simple bit of arithmetic, a quite subtle point of financial theory and another simple bit of arithmetic.

First, a fairly clear and intuitive point of financial arithmetic to get us started. It ought to be pretty obvious that from the point of view of cash flows back and forth in any given year, the following two situations are equivalent:

(Expressing things in terms of % of Greek GDP; the numbers are order-of-magnitude right rather than precise).

Program 1. Greece maintains a primary budget surplus/deficit of 0, and pays zero interest to its creditors.

Program 2. Greece maintains a primary budget surplus/deficit of 0, pays 2.5% of GDP out as interest and borrows 2.5% of GDP in new program lending.

A lot of readers will immediately start objecting that Program 2 is increasing Greece’s debt burden and therefore making it unsustainable and …. NO! STOP RIGHT THERE! I’ve written this elsewhere in a number of places now. The total figure for “Greece’s Debt Burden” is an economically meaningless number. Everyone knows it is going to be restructured at some politically convenient time in the future; it simply can’t be paid back, and so it simply won’t be. So increasing the size of the debt outstanding by 2.5 now just means that you increase the size of the writeoff in the year two-thousand-and-something by the same amount. Concentrate on the flows and only on the flows — the stocks are no longer a useful quantity to think about.

This way of thinking is also a useful prophylactic against any temptation to believe that there might be a “Program 3" under which the interest bill is reduced to zero but the lending continues at 2.5% of GDP. That’s not on the table — or at least, not unless you are prepared to presume a sudden and unilateral gesture of generosity to Greece, which feels unlikely when one remembers that Latvia and Lithuania, to say nothing of the richer creditor countries, would have to vote for it.

So in terms of the flows, the two programs described above are exactly equivalent. But — and this might be a bit counterintuitive — Program 2 is much much more attractive than Program 1 to any lender who knows what they’re doing.

That looks odd; in principle, Program 2 means increasing the lending exposure while Program 1 doesn’t. But we’ve already established that this isn’t true in any economically meaningful sense. And the attractiveness of Program 2 comes from a source that you tend to only learn about in the business school courses, rather than the theoretical version that you get in the economics department.

In the jargon of banking, it’s called “keeping the borrower on a short leash”, and it’s all about control of the situation. In the corporate context, this means that it’s a way in which lenders (who usually don’t have control rights over corporate investment and expenditure) can get those control rights from the equity holders (who usually do). In the Greek context, it’s political rather than corporate control, but the idea is the same.

Under program 1, the lender has given up on all options. If the primary balance appears to be slipping, or some other measures have been taken which are opposed to the lenders’ interests, there is not much they can do because they have forgiven the interest payments and the borrower doesn’t need their involvement any more to pay his or her bills as they fall due. Under program 2, the regular need to make interest payments means that the borrower needs to keep coming back to agree new lending facilities. The need to agree those facilities is a key way by which the lenders can either influence the borrower to take decisions which don’t stray too far from the agreed program, or to cut the whole loan and put the borrower into default if they think it’s no longer worth continuing.

Even in a business context, preserving your optionality can be incredibly valuable. To a group of negotiators like the European Commission side of the troika, whose entire raison d’etre is the exercise of political influence, it’s likely to be incredibly valuable. In fact, it’s quite possibly a deal breaker. If you have a Eurogroup member state which doesn’t want to comply with the agreements which formed the basis for providing the financing in the first place, then it’s politically intolerable to keep on providing that finance, at which point the slippery slope toward Greek euro exit has begun.

So that’s the point of financial theory. Going back to the arithmetic, there’s another quite important point to make about the difference between Programs 1 and 2. Which one of them is better for Greece?

Well, they’re financially equivalent if you consider the only two groups to be “Greece” and “The Creditors”. But the “creditors” who are receiving the interest payments are not identically the same people as the “creditors” who would be extending the new loans. To the extent that Greek government bonds are owned by Greek residents (quite substantial), and that continuing interest payments on them are financed by new lending, Program 2 is potentially materially more stimulative than Program 1.

It’s not too difficult to see why; in Program 1, the primary balance is zero, and because there are no interest payments, the total government deficit is zero too. In Program 2, however, although the primary balance is zero, the overall budget is a deficit of 2.5%. You would have to be in a very odd situation indeed in terms of the balance between overseas and domestic creditors for a deficit of 2.5% not to be a more stimulative budget than a deficit of zero.

Why does this matter? Well, everyone who is looking at this situation closely knows that the really crucial parameter over which the Greece/troika negotiations are going to be had (when the mind games and posturing stop), is the status of the projected primary balance surpluses assumed for the years 2015–20. Under current (ridiculous) forecasts and assumptions, these are meant to go as high as 4.5% surplus. Paul Krugman really clearly shows how much benefit there is to the whole economy by reducing these target to (at the very least) a zero primary balance, and preferably a primary deficit (which would, in my view, count as ending the “austerity” element of the program).

Yanis Varoufakis is no fool, and it’s clear that he’s concentrating on the primary balance element too. But if the public pronouncements of the Syriza leadership are to be taken at face value, they’re negotiating with the aim of getting something in the direction of Program 1 in place — rather than aiming purely at reducing the program surpluses, they also want to reduce the interest bill. In my view, this is economically arse-about-face — on the one hand, it’s less of a stimulus and less of an overall deficit than might be available, and on the other hand, it’s politically toxic to the other side. So it almost looks as if they’re not just allowing the perfect to be the enemy of the good, but sacrificing a chance of an OK deal in order to hold out for a worse one.

Why are they doing it then? Well, political independence is important to Greece too. To a large extent, Syriza was elected on a ticket to bring dignity back to Greek politics. The counterpart of the “optionality” which makes Program 2 so attractive to lenders is that there’s a huge external political constraint on the ability of a democratically elected Greek government to make policy how it wants to. That’s a real and important cost to Greece, although in my opinion describing the situation as “peonage” is really unhelpful, and the inevitable references to Germany and the war even less so.

At the end of the day, Greece had almost complete political and economic autonomy from 1999 to 2008, and look how much good it did them. The reputation of Greek politicians took more than twenty years to drag down to its current status and in my view it’s unreasonable of anyone to expect Syriza to restore it in six weeks. Right at present, they potentially have a chance to end austerity by negotiating hard on the primary balance. Using up any of their negotiating power or political points — and it is not as if Greece starts off with a load of goodwill and plenty of favours to call in — on the debt balance is diametrically the wrong way to go.

Bull Market

A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl

    Dan Davies

    Written by

    Senior Research Advisor, Frontline Analysts

    Bull Market

    A collection of finance and business writing by @alexisgoldstein, @delong, @dsquareddigest, @DuncanWeldon, @felixsalmon, @jamesykwak, @Mark__Buchanan, @WhelanKarl