Merkel vs Lagarde

What began as a battle between the Greek government and the European Central Bank has recently boiled down to an outright face-off between IMF’s Christine Lagarde and German chancellor Angela Merkel.

While Merkel continues to push for the Greeks to pay for years of fiscal negligence through fiscal austerity without new emergency loans, Lagarde and the IMF have carefully adopted the stance that tightened shackles won’t provide a long-term solution to the Greece’s situation due to its rapidly growing national debt.

Lagarde makes an important point. Suppose Greece reaches a balanced budget in, let’s say, 2016. Even with a decreasing growth of the national debt over the next three years, a net debt level of 195 percent of GDP at that point is a fair (some would even argue it is conservative) assumption to make. National GDP contracted by 3.3 percent in 2009, 2.5 percent in 2010, and roughly seven percent in 2011. Assume the tide has turned and things begin to get better, resulting in a four percent contraction in 2012, a 2.5 percent contraction in 2013, and a zero growth in 2014, followed by a modest gain in 2015.

On paper it will appear to be a success-story – “How Fiscal Austerity Balanced Greek Budget,” or something along those lines. But it will be a significantly different Greece that rises from the ashes.

When Lehman fell in the fall of 2008 Greece had a national debt at roughly 110 percent of GDP. In the scenario outlined above, Greece will be facing a national debt at 195 percent of GDP which will have to be dealt with by taxing an economy that is at 85 percent of the 2008-level.

One does not have to be an economist to deem that equation insoluble.

The IMF has therefore argued debt write-downs being the only way to save Greece. But Merkel says no – for little else than political reasons.

Germany is EMU’s key source of economic strength and has contributed vast resources towards the relief programs for the troubled Mediterranean economies. Write-downs of Greek debt will therefore not only hurt Germany’s bottom line but cause upheaval among the German taxpayers who, at the end of the day, will be forced to absorb some of the losses.

Merkel is facing a national election in the fall of 2013. Dealing with demonstrating Greeks is likely a much more preferable situation than stirring up anger among her own constituents.

Allowing for Greece to leave the Eurozone – the Grexit – is neither likely to be proposed by Merkel since that kind of failure to keep the house from collapsing would result in shattering political humiliation. It certainly is not the legacy Merkel would want to leave behind if being ousted from her post next fall.

And while these political games are played, Greeks are suffering.

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