Will Greece be in EMU at the end of 2015?

The Greek political drama is overshadowing the Russian crisis and the plunge in the price of oil.  A review of old and new media coverage suggests that many observers are repeating the same mistake they made 2-3 years ago. We were one of the few analysts that did not expect Greece to leave the monetary union then, and we expect it to remain in the union now.  

Investors understand economic issues but have a blind spot when it comes to politics.  Informed by the liberal and neo-liberal economic determinism, they think politics is simply a function of economic self-interest.  This reductionist approach proved wrong before, and it will likely be wrong again.  

They see monetary union and think it is about economics. Yet, monetary union itself is an economic answer to a fundamental political issue:  Under what conditions could Germany be re-united with the fall of the Berlin Wall.   EMU is fundamentally a political exercise.  

The euro-skeptics smell victory that has eluded them.  Every challenge the euro area faces is seized upon as evidence of the folly of monetary union.  Every problem a member faces can be resolved by dropping out of EMU and devaluing.   Let's not count the chickens before they are hatched.  

Syriza, the left coalition in Greece, is 2-3 percentage points ahead of the New Democracy (ND).  ND's Samaras heads up the current government, which is a coalition with the ND's longstanding rival in Greek politics, the Socialists.    It is certainly possible that Syriza will win the election on January 25 and lead the next government but it is far from a sure thing.   

Greek politics are fluid, and over the next few days, former Socialist Prime Minister Papandreou is expected to form a new center-left political party.  It will capitalize on the rank-and-file disenchantment with Venizelos, the Socialist Finance Minister.  It is unlikely to emerge as a major party, but it may take 1-2 percentage points from Syriza.  

Greek politics very fragmented.  The frustration this causes prompted the electoral reform that grants the top vote getting party 50 bonus seats in the 300-member parliament. While Syriza could get the most votes, it has never reached the level of public support that would give it an outright majority.  Nor is it clear which political parties if any would join a Syriza-led coalition.   

We suspected that Samaras' failure to secure the selection of his presidential candidate, which has led to the early election could see him join the quarter of the Greek population that is unemployed.  In his years in opposition, and now in office, Samaras has alienated some members of his party, which led to desertions to other parties. A new and different candidate for the New Democracy could boost its chances in the election.   If Samaras remains the candidate, he will have to tack to the left and promise stiff negotiations with its official creditors.  

Greek debt dynamics were always going to a challenge when the end of its assistance program drew near.  Samaras had hoped a smooth exit would have stolen some thunder from Syriza, but partly because of the rise of anti-EMU parties various creditor nations, including Germany, this path was blocked.   

The position of both Greece and its official creditors has strengthened over the past couple of years.  Greece's economy shrank by over a quarter and investment plunged by nearly 2/3.  However, the contraction is over, and the economy has begun expanding.   The IMF forecast Greece to grow by almost 3% through 2019.  

More importantly, for its negotiating position, Greece is running a primary budget surplus of around 1.4% last year.    By running a surplus excluding debt servicing costs, means that Greece no longer needs to borrow fresh funds.  It is in repayment mode.  

The concern that a Greek crisis poses systemic risk of the euro area as a whole has lessened. Spain and Ireland, for example, are on the mend.  The banking system is stronger, even if not completely healthy.  Officials have created greater institutional capacity, including facilities such as the European Stabilization Mechanism.   Peripheral markets have shown less sensitivity to developments in Greece.  We note that Italy sold ten-year bonds last week at record low interest rates. 

In heated negotiations, it is not uncommon for each side to accuse the other of blackmailing the other.  Syriza accuses the Troika of blackmailing Greece:  Either Greece cuts its nose to spite its face by enacting even more austerity or the ECB cuts off the life support of liquidity.  The Troika itself has not accused Greece of blackmailing it but that has not stopped numerous observers from claiming exactly that:  Either the Troika renegotiates Greece debt, or the country will default.  

What makes Greece's case different from other debtors who have often used attainment of a primary surplus to squeeze extra concessions from the creditors or defaulted, is that its debt is primarily in official not private hands.   Of the roughly 320 bln euros of debt, only 54 bln is in private hands.  The rest is owned by the EU collectively and individually, the IMF and ECB.   It has long understood that when at the end of Greece's aid program, the official creditors would ease the debt burden by lengthening maturities and reducing interest rates. There is more room to negotiate that the media often suggests and that the pundits as partisans want to recognize.  

Other parts of Syriza's platform are frankly more difficult for the official creditors to swallow. The budget agreements cannot be annulled.  Unwinding some of the austerity measures in terms of civil servant salaries and pensions will destroy the very conditions that allow Greece to negotiate, if not from a position of strength, then a stronger position nonetheless.  There may be room for some additional government spending, but it will not be acceptable to return to the pre-2009 period.  

At the same, it seems politically naive to think that there will be no contagion; that Greece could exit from monetary union in a perfectly calm, orderly and non-disruptive way.   That there has not been financial contagion yet proves very little.   Those arguing in favor of the creditors think that a Grexit would be a wake up to the other anti-EMU parties.  Greece would be a bad example that others would seek to avoid.  

The risk lies in the opposite direction.  If Syriza were to lead Greece out of monetary union, would not others be emboldened?  There are parliamentary elections in five euro-zone countries this year (Greece, Estonia, Finland, Portugal and Spain).  On New Year's Day, Italian President Napolitano indicated intentions to resign following Italy handing over the rotating EU presidency to Latvia.  This presents an important challenge for Italy, where Renzi's structural reforms efforts have been bogged down in Italian politics.  

Podemos in Spain has come from nowhere to lead the polls, and its agenda is not very dissimilar to Syriza in terms of unwinding austerity measures. Would Podemos be fearful of a Grexit or would it be like a shot of adrenalin and encouragement. The risk of political contagion may very well prove to the channel of economic contagion.  

The Greek people have withstood significant human and social costs.  There is now light at the end of the long tunnel.  Exiting the monetary union would trigger a new political and economic crisis in Greece.  Unemployment would rise, the economy would contract.  In an unprecedented way, it would default to the IMF, ECB and EU and several countries that made bilateral loans.   As was the case before, and it remains true now--inside EMU is difficult for Greece, but outside would be hellish.