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A New Greek Test for Europe

PRINCETON – Over the last year, it has been easy to lose sight of the Greek debt crisis. Brimming with official funds, Greece was apparently on the mend. Though privatization plans lagged, the Greeks won high marks for doubling down on fiscal austerity. In Europe’s summer of quiet triumphalism, ever-lower expectations were easy to beat.

But Greece is set to test Europe again, with a vengeance.

Greece’s crisis was spectacularly outsize. After it was revealed that successive governments had misled their way to mammoth fiscal deficits and macroeconomic imbalances, Greece lost access to international bond markets. Since 2010, the country has been dependent on unprecedentedly large official bailout funds. But, because Greece’s creditors – the International Monetary Fund and European governments – misread the challenges facing the country, the rescue merely delayed the inevitable sovereign default and caused the Greek economy to contract sharply, magnifying the pain.

The hope was that the Greeks would ultimately bear their own burden. That was never realistic. The Greek crisis was always destined to spill across national borders – the question was who would share the cost.

Today, the leading edge of that dénouement is the impending decision on the next round of Greek aid, which threatens to break the mold on the scale of official debt forgiveness, defy the IMF’s presumed insulation from default, and fundamentally alter the eurozone’s legal framework.

The conclusion that Greece needed official loans to repay its private creditors ensured that Greek debt remained large, compelling eurozone leaders to demand economically debilitating fiscal austerity. Last year, it became clear that Greece could not repay its official creditors on the agreed terms. But the European debt-forgiveness plan, though painstakingly crafted, was bogus. Continued reduction of interest rates and extension of repayment maturities have served only to prolong Greece’s struggles.

Greece has so far repaid almost none of the €282 billion ($372 billion) in loans that it has received since 2010. And matters may be even worse. Some analysts argue that, given guarantees of debt incurred by public corporations, the Greek government’s obligations are even higher. To escape from this morass, Greece needs a massive debt write-down.

But there is a twist. Virtually all of the debt repayments due in the next few years are to the IMF, whose implicit status as “senior” creditor ensures that it is repaid first. Because Greece is rapidly running out of cash, it will first have to borrow more from either its European neighbors or the IMF itself. If the IMF were to ease the terms on its Greek loans, it would likely face fierce protests from its less wealthy debtors and risk compromising its status as senior creditor – an outcome that even the Fund’s largely quiescent Board of Governors is unlikely to accept. The Fund, having swooped in to pluck Greece from the abyss, is ready to step back from the brink.

For that reason, European governments will probably lend new money, despite knowing that they will not be repaid. For the creditor countries’ leaders, a write-down would mean breaking the promise that their taxpayers would not foot the bill – a pledge that also formed the legal basis for supporting Greece. The European Court of Justice ruled that loans to protect financial stability would not violate the Lisbon Treaty’s “no bailout” clause, provided that their terms were “reasonable.” But how reasonable is it if Greece does not have to fulfill its repayment obligations?

Despite domestic opposition, German Chancellor Angela Merkel decided to commit to keeping Greece in the eurozone, because the risk that a Greek exit would precipitate the monetary union’s disintegration was deemed too great. But this logic failed to account for the political ramifications, which threaten to undermine European unity further.

German voters – who will head to the polls later this month – are unmistakably anxious. While it may be too late to avoid forgiving Greece’s existing debt, Germany’s next government will not have a mandate to provide more loans. As a result, important projects like establishing a European banking union, which would require a fiscal backstop, are likely to be delayed or even endangered. The practice of presenting technocratic faits accomplis to national parliaments will only breed deeper resentments.

To be sure, there is always the possibility that Greece’s increasingly dire situation will finally catalyze the creation of a democratically legitimate pan-European bailout fund that provides automatic and unconditional relief to struggling countries. The European Union would thus be transformed into a true federation, the United States of Europe. That would be a triumph for the European project.

Given the improbability of such an outcome, Europeans must brace themselves for another bout of political and legal turmoil. The Europe that emerges from it could look, for better or worse, very different from the Europe of today.