Eurozone crisis: Troika's gunboats will get their way, at a cost

• 
• • Larry Elliott, Economics editor
  • guardian.co.uk, Sunday 15 January 2012 16.20 GMT
  • Article history

Demonstrators clash with riot police in front of the Greek parliament in Athens. 'There is rising despair, sullen anger and a lot of fear. The mix is combustible,' says Prof Costas Lapavitsas. Photograph: Angelos Tzortzinis/AFP/Getty

The warships have been replaced by spreadsheets. Back in 1850,Greece knew it was in trouble when the Royal Navy arrived at Piraeus. This time, the pressure comes from banks, hedge funds and the team of officials of the International Monetary Fund (IMF), the European Central Bank (ECB) and the EU, who will take up residence at one of the swankier hotels in Athens.

For students of history, what is happening in Greece this week has echoes of the Don Pacifico affair, the classic case of British gunboat diplomacy in the mid-19th century. David Pacifico was a Portuguese Jew who had never set foot in Britain but had British citizenship by virtue of being born in Gibraltar. He became the Portuguese consul in Athens, where his house was burned down by an antisemitic mob. After unsuccessfully appealing to the Greek government for compensation, he asked Britain for help, and his case was taken up, with gusto, by the foreign secretary, Lord Palmerston. A naval squadron was sent to the Aegean, Greek ships were seized and Piraeus, Athens' port, was blockaded. Don Pacifico got his compensation.

Greece's modern-day international creditors will not be so successful with their power play and are reconciled to writing off some of the money they are owed. A three-way game of bluff is currently in progress between the Greek government, the hedge funds and bankers, and the troika (the IMF, the ECB and the EU).

The troika is seeking to put pressure on Athens and the creditors to agree to a deal that would result, eventually, in Greece's national debt falling from 180% to 120% of national output. Christine Lagarde, the managing director of the IMF, is warning both sides that they have much to lose if the talks, which broke up on Friday without agreement, collapse. The Greek government will not get the next tranche of its bailout and will be unable to pay its bills within a couple of months. That would almost certainly trigger a debt default in Greece, with knock-on effects across the rest of the eurozone. The creditors are being told that it will be a pyrrhic victory if turning the screw too tightly on Greece deepens the crisis in Italy and Spain.

The Greek government, for its part, is aware that it could hold the fate of the entire eurozone (and perhaps even the global economy) in its hands. Greece is a small country with a history of economic mismanagement, so there is no real reason why its problems should spread. Then again, Lehman Brothers was a small investment bank with a history of mismanagement, and there was no real reason why its problems should have spread either.

Banks and hedge funds are playing hardball because they know that Athens needs the debt writedown and that the troika is desperate to avoid a Greek default. It is international finance's version of Sartre's Huis Clos, a vision of hell where three people who loathe each other are stuck in a room for eternity.

Despite the current hiatus, some sort of deal still looks likely. It will be a fudge, with the Greeks getting some debt relief but not enough to make a real difference to their economy. Old bonds will be exchanged for new bonds, but according to Professor Costas Lapavitsas at the School of Oriental and African Studies in London, the new debt will be made subject to British law so Greecethe Greek parliament cannot change that the payment terms. "There is rising despair in Athens," Lapavitsas says. "There is sullen anger and a lot of fear. The mix is combustible."

The troika arrives in Athens on Tuesdayand is expected to try to bang heads together when the debt talks restart on Wednesday. In reality, though, the best that can be achieved is to prolong the agony by buying Greece a little more time. Unemployment is above 18%, private and public investment is collapsing, exports are weak and consumers are hoarding what little money they have. Greece needs far deeper debt relief than what is on the table if it is to have even the remotest chance of a sustained recovery both in its economy and its public finances.

Greece's lesson for policymakers across the world is simple: you can't cut your way back to prosperity. A country's debt to GDP ratio is made up of two parts, national debt and the size of the economy. If you make the economy smaller (and Greece's economy has shrunk by more than 15%), it is terribly hard to reduce the debt-to-GDP ratio, even if you raise taxes and slash spending.

Belatedly, perhaps, this was the message from Standard & Poor's last week when it downgraded nine eurozone countries. S&P said it was a mistake to blame fiscal profligacy alone for the monetary union's crisis and noted, quite correctly, "divergences" in economic performance between peripheral eurozone countries and those at its core. It then added: "A reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues."

It is worth thinking through what the consequences of this are likely to be. First, Greece will test policymakers' ability to rethink an approach hitherto dominated by austerity. At the moment, it looks as if the test will be failed.

Second, there will be further downgrades during the course of in 2012 as the eurozone economy contracts. S&P could hardly have been more explicit about the "self-defeating" nature of what is happening. Fresh downgrades will push up the cost of borrowing, making recovery even more difficult.

Third, the credit-rating agencies face a backlash, which in this case is completely unjustified. S&P, Moody's and Fitch were legitimately criticised for giving AAA ratings to the US sub-prime mortgage market, but they are quite right to point out the deteriorating state of public finances in the eurozone.

Fourth, the ECB will be ever more active in an attempt to buy the eurozone some time. It may prove sporadically successful in doing that but the single currency's structural problems will continue to surface.

Fifth, those who favour the teachings of the "Austrian school" may be right when they say that the debt crisis will only be ended by a purging of the rottenness from the system, but they should be explicit about what this means: a break-up of the single currency. The strains will simply be too great for the weaker members.

Finally, the warning from S&P has implications for countries outside the eurozone. It will be interesting to see whether Britain remains the poster child for the ratings agencies, because at best the economy will stagnate this winter and a double-dip recession is a very real threat.