How a Radical Greek Rescue Plan Fell Short

ATHENS—Two years after Europe bailed Greece out to protect the euro, the rescue has become a debacle that threatens to unravel the common currency. After Greece's May 6 elections left pro-bailout parties too weakened to govern the country, more elections are likely in June, with no guarantee a stable government will emerge. By next month, Athens must identify €11.5 billion, or $15 billion, in fresh spending cuts or face suspension of the international loans it needs to pay pensions and run schools. If it doesn't get the money, it would eventually have to print its own.
Greece's growing turmoil is the culmination of a radical austerity experiment and botched economic overhaul that have pushed the nation to the brink of social and political breakdown. The story of the ill-fated bailout suggests that forcing deep austerity on individual member states won't save the euro and may worsen its crisis.
Above all, Greece's example illustrates the conflict between Germany's tough terms for aiding other euro members and the amount of pain other societies can bear. Greece's fate shows that what it takes to sell bailouts to a skeptical German public can be politically calamitous in Europe's indebted south.
"The program is suicidal, not only for Greece but for the euro," says Louka Katseli, a former Greek economy minister. "In Spain, Portugal, Italy—everywhere, the same mistake is being made," she says, referring to the European Union's insistence on slashing spending in a recession.
Germany reiterated on Wednesday that Greece needs to stick to its austerity promises; euro-zone governments decided on Wednesday to postpone part of Greece's next aid payment as a warning to Greek politicians.
Greece's bailout by the EU and International Monetary Fund is the costliest financial rescue of a nation in history, with paid or pledged loans totaling €245 billion. It has already involved the biggest-ever sovereign-debt default, a debt restructuring that wiped out more than €100 billion of Greek bond debt.
Yet the restructuring left Greece with two mountains to climb: curbing a still-rising debt more than 1.5 times the size of its economy, while forcing down wages and prices to make the country competitive.
Straining to keep Greece afloat, the EU and IMF doubled their bet in March, greatly expanding the loan program despite the country's deepening political paralysis.
Responsibility for the mess, many of those involved in the effort say, lies with a Greek political class that couldn't or wouldn't reform the country, an unrealistic program that assumed a quick economic recovery despite draconian austerity and crushing debts, and growing mistrust between Greece and its creditors.
"It was almost a mission impossible," says George Papandreou, the luckless Greek premier who negotiated the original bailout and then was forced out by a party revolt last fall.
Mr. Papandreou says that when he asked German Chancellor Angela Merkel for gentler conditions in 2010, she replied that the aid program had to hurt. "We want to make sure nobody else will want this," Ms. Merkel told him.
Greece's economy has already shrunk by 14% in the past three years, and IMF officials privately expect a further 6.5% contraction this year. Something has to give, and it could be the boundaries of the euro.
Europe fears that a Greek exit from the euro could spur massive capital flight from Portugal, Spain or other struggling euro members. Some European officials argue privately that the euro could cope with a Greek exit because markets understand that Greece's debt crisis is uniquely severe.
Others worry that by triggering runs on banks and government-bond markets it could endanger the currency itself. That would present Germany and Europe's north with a terrible choice: to watch the centerpiece of Europe's decades of political integration collapse or to rush into a deeper fiscal union, including common bond issuance, to save the euro.
When the IMF and European countries banded together in May of 2010 to offer Greece a €110 billion rescue, leaders believed they had acted boldly to avoid calamity.
The deal required Greece to get a grip on public spending and tax collection while revamping a bloated bureaucracy and jungle of laws that had rendered its economy internationally uncompetitive.
While everyone accepted that Greece needed fiscal retrenchment, the IMF argued for giving structural changes priority and making the spending cuts gradual, to protect the economy.
Germany said no: Structural reforms would take place at the same time as drastic austerity to bring down the budget deficit—15.8% of gross domestic product in 2009—to under 3% by 2014. The timetable proved unrealistic: Spending cuts and tax increases pushed the economy into such a deep recession that the deficit got stuck at around 10% of GDP.
Usually when the IMF imposes austerity, it makes a country devalue its currency, in the hope its cheaper exports will offset falling domestic demand.
But Greece no longer has a currency of its own to devalue. Its downward spiral bears increasing resemblance to Argentina's a decade ago. Argentina tried to maintain a fixed exchange rate to the dollar even as IMF austerity drove it deeper into recession, ending in social unrest and political breakdown.
From the start, Greece's surfeit of debt undermined its chances. Mr. Papandreou's financial adviser, Lazard Ltd., told him the country's bond debts were unsustainable and needed restructuring.
The head of the IMF at the time, Dominique Strauss-Kahn, was open to it. But Europe wasn't. France and the European Central Bank feared that a Greek default, even via a negotiated restructuring of bonds, would undermine trust in other euro members' debt. Germany thought debt forgiveness would relax the pressure on Athens to make other changes.
"I'd like to cut my debt in half too," Ms. Merkel told Mr. Papandreou during a meeting at the Berlin chancellery, according to the Greek premier.
Despite Greece's concerns over the plan, its efforts to change began strongly. Polls showed solid public support for taming bureaucracy, corruption and tax evasion, and scrapping the privileges various interest groups had won over the years. Lawyers, taxi drivers, railroad employees and many other groups enjoyed protection from competition or special tax or pension perks, creating cartels and waste.
Finance Minister George Papaconstantinou attacked the budget deficit. Sharp spending cuts and tax boosts brought the deficit down to 10.6% of GDP in 2010. But change quickly fell victim to party politics.
Firebrand opposition leader Antonis Samaras, head of the conservative New Democracy party, denounced the tough bailout terms and declared that local elections in November 2010 were a referendum on the ruling Socialist party, known as Pasok. Mr. Papandreou called on Greeks to back him or sack him. Pasok won the elections, but by a much smaller margin than before.
"Voter fatigue was obvious," says Haris Pamboukis, a cabinet member at the time.
Mr. Papaconstantinou found himself increasingly isolated in cabinet. The U.K.-trained economist was an outsider in Greek politics. He couldn't get other ministers to shut loss-making state industries and pointless army bases, or to ax thousands of civil-service jobs created in return for votes. Nor could he reduce Greece's chronic tax evasion, abetted by corruption among tax inspectors. 
He did what he could: cutting pensions and public-sector pay, while raising sales taxes. But that sapped consumer spending. Shops and small businesses failed. Unemployment surged. Public hostility grew.
Civil servants facing pay cuts went on strike, including at the finance ministry. "It was a case of 'you pretend to pay me, I pretend to work,' " one minister says.
In spring 2011, austerity and collapsing business and consumer confidence pushed the economy into free fall. Protests rocked the center of Athens. There wasn't enough support in Parliament to pass the next set of austerity measures.
In June, Mr. Papandreou replaced his finance minister with the premier's biggest rival, Evangelos Venizelos. Europe's ebbing trust in Greece soon plunged.
Mr. Venizelos, who has been described as one of the most eloquent Greek orators since ancient times, took the finance job reluctantly, fretting that the unpopular task could destroy his political ambitions, colleagues at the time say.
Many Greeks hoped he would be a tough negotiator with Europe and the IMF. Mr. Venizelos's first foray was at a finance ministers' meeting in Luxembourg. His long speech hit all the wrong notes.
He told his euro-zone peers they needed to relax Greece's austerity targets, citing the growing political difficulties. He called privatization goals unrealistic and blamed EU law for making asset sales complicated. He suggested Europe had no choice but to lend more money because a Greek bankruptcy could destabilize the euro zone. Greece's crisis "is a European problem," he said.
Other ministers reacted with fury. To them, it sounded as if he was trying shirk hard decisions while blackmailing his creditors. They lambasted Mr. Venizelos until 2 a.m., saying Greece had to rebuild its credibility before it got any more aid.
Instead of releasing a quarterly loan payment as planned, the ministers put it on ice until Athens enacted more austerity.
As the meeting ended, the bruised Mr. Venizelos tried once more to secure the money, to allow him a political victory at home. "I'm here for the first time," he pleaded, according to people who heard him. "It would be a bad signal if the tranche is not released." Jan Kees de Jager, the equally burly Dutch finance minister, erupted in anger.
Part of the government's problem, Europe knew, was that Mr. Samaras was assailing the austerity measures, and his conservatives had overtaken Pasok in opinion polls as a result.
Ms. Merkel and other heads of European conservative parties summoned Mr. Samaras to Brussels on June 23. For three hours, they pressed him to back the program. Mr. Samaras told them the program would fail. "Then you will need a plan B, and I'm the one who can bring it about," he said.
Ms. Merkel asked Mr. Samaras what he proposed. He said he agreed with cutting the budget deficit—but he wanted to do it by cutting taxes to spur the economy.
A tax cut would create a bigger budget shortfall, other conservative leaders said. Only Viktor Orban, Hungary's maverick premier, sided with Mr. Samaras. "Some understand that we are right," the unbending Mr. Samaras told reporters after the meeting. 
Mr. Venizelos tried again to force a relaxation of the bailout terms in September. At nighttime talks in his finance ministry, inspectors from the EU and IMF pressed him to lay off civil servants and shut loss-making state enterprises.
Mr. Venizelos refused. "I don't want to enter into a technical discussion with you. The issue is political," he said, according to people present. (Mr. Venizelos didn't return messages requesting comment.) The inspectors told him they couldn't offer any political concessions, and left town without recommending the release of Greece's next slice of aid.
The finance ministry had less than €1 billion left in its coffers. The monthly bill for public wages and pensions was around four times that. Greece's government avoided bankruptcy only by not paying its suppliers.
Mr. Venizelos had to appeal again to European finance ministers, who met in Wroclaw, Poland, in mid-September. The night before the meeting, Germany's Wolfgang Schäuble collared Mr. Venizelos in their hotel's cellar bar and made it clear over a bottle of fine wine that Europe was getting fed up with Greece.
"If you want to stay in the euro, you have to act," Mr. Schäuble said.
Greece did want to stay in the euro, Mr. Venizelos said.
Mr. Venizelos became more cooperative, euro-zone officials say. But the Greek program was badly off track. The government had made little headway on its long list of promised changes to reduce red tape, increase competition and attract investment.
In October, the IMF, now under the more stringent leadership of former French Finance Minister Christine Lagarde, forced Europe to recognize reality: The numbers didn't add up.
That forced European leaders to grant Athens debt relief. An EU summit on Oct. 26 led eventually to a 53.5% "haircut" in Greece's bond debt, coupled with more aid loans. But by this time most of Greece's debt was owed to euro-zone authorities and the IMF, rather than to private bondholders. A bond restructuring that could have worked at the outset had a limited effect: Greece's debt fell from €356 billion in 2011 to a projected €327 billion this year.
Ms. Merkel and other euro-zone leaders thought the haircut-and-new-loans deal had settled the Greek question. But in Athens, the government was falling apart.
Amid rising social unrest and fraying support in parliament, Mr. Papandreou proposed a referendum on the expanded bailout. 

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