At this point, default within the eurozone is the best case scenario for Greece. Grexit is still a distinct possibility. All potential best case scenarios are out the window. Below is my assessment on how we got here.

The original sins of 2010 and 2012

First, let’s remember that back in 2010, most of the creditors to Greece were in the private sector, many of them banks in other Eurozone countries. At that time, the fragility of the European and global economy, and of the European banking system was much greater than it is now. And this caused Europe to panic. What’s more is the EU was able to corral the IMF into joining the EU in bailing Greece out, even though doing so broke its own rules and disregarded the analysis of its own economists. This was the original mistake and the whole chain of events since then has been a futile attempt to justify that original decision.

As Irish economist Karl Whelan noted last week, before the euro was born, most well-known economists believed the no-bailout rule was inviolable. The thinking was that markets would get it that some countries were more likely to default than others and they would impose an adequate premium on the bonds of those countries to reflect this risk. But of course, these economists were wrong. Markets don’t react that way because Knightian uncertainty can never be priced in to markets until an uncertain event materializes as real. Look at all of the outlier scenarios that have crystallized over the past years and months and we see panic and a flight to quality every time. This is true even today in the wake of the Greek capital controls and the Puerto Rico governor’s admission his government is insolvent. These were known events but they were uncertain. And as Alan Greenspan famously said in 2004, “when confronted with uncertainty, especially Knightian uncertainty, human beings invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity.” That’s what we’re seeing.

Now let’s remember we haven’t even had a default yet. Nor has their been a Greek re-denomination out of euros, the so-called Grexit. And clearly, if we are seeing contagion after capital controls, when those events crystallize, we will see contagion yet again, but in greater measure.

Going back to the ‘original sin’, however, I didn’t think the Germans would assent to bailing out Greece. I even wrote reasons why. I did have a weasel paragraph at the end to give me an out: “I see it as unlikely that any deal – bailout via the EU, IMF bailout or backdoor help via quasi-fiscal measures from the ECB – can be reached unless Greece agrees to austerity measures.” And that suggests I was right that no deal could be reached without massive austerity. But, thinking back to my mindset at the time, the title of the post, and all the words leading up to my conclusion, it is clear that I didn’t believe the Germans would do it. But they did. Why?

The most obvious answer is the weak banks. The now deceased former German Central Bank Head Karl Otto Pöhl said at the time that it was all about rescuing weak German and French banks – and rich Greeks too. This is most definitely true. For example, back in 2012, the FT’s James Mackintosh quoted JPMorgan which reckons only 15 billion euros of 410 billion in ‘bailout’ funds actually went to the Greek economy. The rest went to creditors of the Greek government.

JP Morgan estimates only €15bn of €410bn total “aid” to Greece went into economy – rest to creditors. No wonder they are cross — James Mackintosh (@jmackin2) June 15, 2012

And I wrote extensively in 2010 and 2011 on the exposure to Greek and other peripheral sovereign debt. See, for example, my posts:

Contagion risk was real and it was significant.

But another reason that the Greeks were bailed out is that Germany is also concerned about its own debt sustainability as a part of the eurozone. Let’s remember that at the time of the original Greek bailout, Germany was in violation of the stability and growth pact. And Germany was formally in violation of the Maastricht treaty repeatedly after 2002, under both SPD and CDU-led governments. The financial crisis caused German government debt to go from well within reach of the 60% hurdle to over 80% of GDP, well outside the hurdle for at least a decade. This was an embarrassment for many in Germany.

How could the Germans – who feared the fiscal profligacy of the likes of Italy and Greece – preach to others on fiscal probity if they didn’t get their own fiscal house in order? And if the Germans had been forced to bail out their banks for their reckless lending to the Greek government, you would have seen a massive increase in German government debt. So they bailed Greece out and socialized the losses against punitive austerity terms to make an example out of Greece.

The new eurozone protocol for bank bail-ins is also an attempt to address this problem after the fact. If formal bank creditors are on the hook for losses before taxpayers are, then the governments of the eurozone won’t have to bail out banks, which would have forced their debt loads higher.

So all of this comes down to using Greece as a whipping boy to prevent contagion to the rest of the eurozone governments, which cannot be bailed out by ECB monetary financing as this is forbidden under the Lisbon Treaty. If Greece had gone down, euro banks would have gone down, European taxpayers would have been on the hook, and the contagion would have been palpable. Without an ECB backstop, other periphery countries like Portugal might have defaulted and the European economy would have been wracked by the mother of all crises. The bailout of Greece was designed to prevent this outcome and it has done.

Why the differential treatment?

Now, having bailed Greece out under punitive conditions, the Troika had to decide what to do when austerity caused a debt deflation. Their initial economic projections were horrible and now they were faced with a shrunken economy without a shrunken debt load.

Always remember the original Greek aggregate demand estimates. They were dead wrong. (And even the new projections proved woefully inadequate in understanding how debt deflation shrinks demand) pic.twitter.com/YnafqMVa8Z — Edward Harrison (@edwardnh) June 23, 2015

So,faced with a clear failure, the institutions bit the bullet and forced writedowns – but only on the private sector. The flaw here then was that yet again the Institutions were engaged in extend and pretend. You need an adequate mix of reduced debt payment NPV, creditor-debtor deal alignment, and economic growth. Think of it from the bankrupt private debtor perspective. The creditor knows that if it does not relent in its demands, the debtor will be forced into bankruptcy and the creditor’s recovery will be less. So creditors try to allow companies with salvageable situations to recover and to grow in order to maximize debt net present value recovery.

In the case of Greece, it has taxing power that allows it to collect ‘revenue’ in good times and bad. Unlike a private sector debtor there is neither a formalized bankruptcy process nor is there an a priori decline in revenue due to debt distress since sovereigns can always increase taxes (revenue) while private debtors must rely on cost cutting once distressed. But I would assert here that a public debtor faces similar revenue shortfall constraints when distressed, and this is precisely why the Troika budget estimates fell short of the mark yet again in 2012. They needed to either bail in the official sector or move to a more backloaded austerity paradigm to promote growth.

I suspect not all parties of the Troika were interested in only debt and economic recovery because of the differential treatment Greece has enjoyed. Look at IMF debtors Iceland and Ukraine, for example. In Iceland, Poul Thomsen, the man who is now running the IMF program in Greece took a very different approach in Iceland.

Iceland’s IMF program did NOT seek to impose austerity during recession (unlike in Greece) https://t.co/E0gd8zIRLdpic.twitter.com/kLKOBadCXM — Edward Harrison (@edwardnh) June 15, 2015

And now Iceland has gone from economic basket case economic survivor.

In the case of Ukraine, the debt load is considered too large at about half the size of Greece’s relative to GDP. And the IMF are insisting on official sector involvement in writedowns before Ukraine can enter into an IMF program. Ukraine is now seeking a 40% cut in the face value of their bonds – and the IMF is supporting them in this endeavour.

IMF wants writedowns and a 71% govt debt/GDP target by 2020 for Ukraine (but a 120% target for Greece, no writedowns) https://t.co/by17oqQxZM — Edward Harrison (@edwardnh) June 26, 2015

The differential treatment between Iceland, Ukraine and Greece speaks to non-financial factors influencing the situation in the negotiation in Greece.

I believe that the Greece debt bailout negotiations are really about France, not Greece. Here’s why.

As I put it earlier in the month at Credit Writedowns Pro: “The eurozone negotiators are most concerned about Greece as a precedent and example for other countries in terms of so-called reforms. We’re talking about pension reforms, labor reforms, privatization and so forth. German Finance Minister Schäuble has been quite explicit about this. In Mid-April, he gave a talk at the Brookings Institution in which he said that the French wish they had a Troika program the way Spain had one, in order to make structural reforms easier to implement. The French government denied Schäuble’s comments were true because they smacked of anti-democratic fiat from above (link in French).

“But the incident made clear what is happening in Europe. Individuals in Europe who want less socialism – for lack of a better word – are using this crisis to force their agenda. And in some ways, they have exacerbated the crisis in order to make this agenda stick. With Greece, then, there is less room to compromise than meets the eye, particularly because the Greeks have been the most deviant from the desired model of structural reform. The thinking, therefore, is “if we let Greece off the hook on these issues, the others won’t implement the necessary reforms either. And France isn’t even in a program. The socialist government there has much less political pressure to comply with this agenda. Unless we get reforms, there will not be economic harmonization and we will be back in crisis in short order.””

Greek default is coming, and perhaps Grexit

Frankly, these tactics were never going to work. The reality is that the political agenda of the Institutions is not compatible with growth in the Greek economy. The Greeks need debt relief like Ukraine and near-term economic growth like Iceland. Doing this in a way that aligns debtors and creditors through some sort of debt arrangement that is dependent on economic growth – as Yanis Varoufakis has proposed – makes the most sense. Debtors that cannot pay, wont repay. They default and then suffer the consequences.

Unfortunately, the consequences of the inevitable Greek default will be borne by the wider European economy as well. We see contagion today already after the imposition of capital controls. I reckon we will see even more when Greece defaults and if they are forced out of the eurozone. Let’s remember the Greek government stance.

Capital controls within a monetary union are a contradiction in terms. The Greek government opposes the very concept. — Yanis Varoufakis (@yanisvaroufakis) June 28, 2015

When I read this statement by the Greek finance minister, I see him as saying that the Greek government will not remain within the eurozone for long with capital controls in place. I see Yanis Varoufakis as saying that he wants a deal with the creditors that will allow Greece to remove capital controls, or Greece’s exit from the eurozone is inevitable.

Now the Greek banking system is near collapse. I believe that some bank stocks may not open for trading when the Greek stock market opens because bank nationalization is a distinct possibility here. But even if the Greek banking system collapsed, let’s remember that there is no formal mechanism for Grexit. Thus, it is still not clear to me that a banking system collapse necessarily means Grexit, something that involves a unanimous vote of eurozone members including Greece and the printing a new currency plus thousands of other preparatory moves. Instead, we are going to be in a limbo period with a parallel currency in place in Greece, with Greece effectively shut out of the eurozone while trapped within it. This is going to be a period of extreme uncertainty regarding Greece and regarding the inviolability of the eurozone.

I believe, given the economic disaster that Greece has been through and the likelihood that the Institutions will insist on more measures that guarantee further economic shrinkage, Grexit is likely in the medium-to long-term. This has always been my position. However, now we are seeing the possibility of an uncontrolled Grexit, something that occurs under duress and crisis. If this does occur, it would be a catastrophic error by the EU and re-introduce re-denomination risk for each and every member of the eurozone. Such an event would represent an extreme policy failure that assures the eventual breakup of the eurozone unless institutions are reformed drastically.

What we will need to see over the coming days is how much contagion we get to the rest of the eurozone and how much the ECB is prepared to back its national governments with quantitative easing. My sense is that we can get through this if there is no Grexit, but if Greece leaves the eurozone, the existing tools may prove insufficient.