The First Greek Bailout: Varoufakis v Blanchard

by George Hatjoullis

The previous two blogs include the views of Varoufakis and Blanchard on the first Greek bailout. This is interesting because both argue that now Greece needs debt relief if it is to achieve a sustainable debt path. However, their perspectives on the first Greek bailout are quite different. Varoufakis argues that the first Greek bailout was about bailing out French and German banks and that was all. Blanchard has a different take. He notes that perceived contagion risk was a concern (I can confirm this) and that this deferred restructuring for two years. This benefitted foreign banks holding Greek debt but also Greek banks, which held one-third of this debt. Blanchard ignores the holdings of Greek debt by Greek banks that were subsidiaries of foreign banks and holdings of Greek debt by Cypriot banks.

Blanchard notes that a haircut was eventually imposed on private sector holdings two years later. True, but the foreign banks had two years to adjust their positions and the ECB was a not insignificant buyer in this period. Those foreign banks that were well advised did reduce their holdings. Some (Cypriot) banks seemed to have increased their holdings, which resulted in another crisis. Blanchard is also correct in that the terms of the new official debt (to which private debt was effectively converted) carried better terms. He is also correct that Greece had a primary deficit of 10% in 2010 so substantial fiscal adjustment was inevitable (Varoufakis chooses not to note these aspects).

Blanchard admits that the IMF miscalculated the collapse in Greek GDP (and then some). However, he claims that this had nothing to do with the austerity (or fiscal consolidation in economist parlance). He blames the initial situation (above potential growth to start with) and insufficient reforms. It was Greece’s own fault according to Blanchard. This is all true but he does not mention the synchronised austerity across the EZ that was crushing demand in Greece’s main economic trading area. The absurdity of the response to the crisis was in requiring all deficit countries to adjust at the same time. This was a huge fiscal shock to the EZ and affected each member state in an unpredictable way. It certainly contributed to the depth of the collapse in Greek GDP.

Varoufakis concludes that the EZ faced a stark choice in 2010 of removing Greece from the EZ or moving to a federation. This is a gross over simplification. Moving to a federation was not an option. Removing Greece was not an option. The legal obstacles to both were insurmountable in the time available. Germany took control (France became mute in 2010 and has only now found her voice again). The German solution was impose fiscal orthodoxy on the system. A version of fiscal orthodoxy was always used to paper over the lack of a federalist structure, in the guise of the growth and stability pact. However, it was toothless (even Germany had thwarted it). Germany saw an opportunity to use the crisis to impose it as the backbone of the EZ. It took it. The reason for wanting this option is moral hazard. In the absence of a federal structure (thus national sovereignty dominating fiscal policy), members could get themselves into financial difficulties and then expect to be bailed out in order to ensure the stability of the EZ. Fiscal orthodoxy is one way of eliminating this possibility. Arguably, in the absence of a federal structure, it is the only way to eliminate moral hazard.

The question arises about the even-handed treatment of different member states. Varoufakis implies that Greece was treated more harshly. It was and still is being treated so. I would argue that so was Cyprus (I have so argued in early blogs). The reason is a lack of trust. Greece had dissembled to get into the EZ. It made promises on reforms it did not keep. It was, in German eyes, an unreliable member of the EZ. Cyprus banks had allegedly conspired to launder money for the Serbs and the Russians and thus also viewed as unreliable. The way Cyprus had gained entrance to the EU whilst rejecting the Annan plan had left a taste of distrust. It might also have something to do with Catholicism v Orthodoxy and the alignments during WW2. Who knows? The fact remains Greece is not trusted and this is a fundamental problem. A currency union requires complete trust unless mechanisms to avoid abuse are in place.

Fiscal orthodoxy is one such mechanism so why is Greece still being treated harshly? The problem is the need for debt relief. Berlin fully recognises the need. It simply does not want to give it. Part of the fiscal orthodoxy is no default in the EZ (which is rich coming from Germany). It is not illegal (as Berlin claims) because the ESM is not actually an EU institution governed by EU Treaty. However, they insist on it because Berlin fully intends to bring the ESM within EU law and does not want any precedent. Greece is, of course, a special case and this is not really a problem. It will not open other demands for debt relief but Germany is using this possibility as an excuse. One can not help however but suspect a vindictive element. In this respect Varoufakis has a point and Blanchard is being deliberately obtuse.

It may be that Syriza could never overcome this antipathy that Germany (and their acolytes) hold for Greece. Unfortunately, we will never know because they did not try. The Syriza approach has been confrontation with Berlin. This was never likely to work. It merely deepened the antipathy and distrust. A better approach would have been to speak softly and let sympathetic players, such as the IMF, France and even Italy, argue the case. It was best not to mention the war, Germany’s tendency to default and the debt owed to Greece. The Syriza attack was not about democracy it was about sovereignty. Each member is a democracy and each member gives up some sovereignty to join the EZ. Greece is challenging the institution of the EZ and its right to impose its will on members. It will not be allowed to get away with this and unless it complies it will isolated from the other members.

Today we have the summit of the 28 EU members but the agenda is Greece in the EZ. The fact that such a summit is taking place is in itself remarkable. In my view Greece’s future was sealed when the summit was announced and I styled it “Funeral in Brussels’ (apologies to Len Deighton). Greece will be offered such onerous terms for continued membership that it will prefer to co-operate with a ‘temporary’ exit from the EZ. No one can force Greece out but an agreement between all parties is legal. Greece will need to agree but given the choices why would it not do so? The German Finance Ministry has already flagged the idea but it was to be expected. It is the orderly or agreed exit to which I have previously referred.

The blame game is pointless. I have been a professional participant and observer of this saga since the snake dominated FX trading in Europe. The architectural faults in Maastricht were widely understood at the time of the Treaty. The point was to get the EMU train rolling and lay tracks as the train moved forward. Admission to the train was nominally strict but some tickets were discounted. One used a forged ticket. Once board the doors were locked and no one allowed to leave, but the passenger with the forged ticket may be about to ejected in the interest of harmony.


Within minutes of publishing the blog Tusk announced that the 28 member EU summit this evening has been cancelled. The Twitter-sphere regards this as positive but I remain circumspect. It most likely reflects deep divisions within the EZ and the impossibility of coming to a set of choices that the 28 EU group might discuss. Could it be optimistic? This depends on Merkel replacing Schauble. As long as he is finance minister the pressure on Grexit will remain.