How Greece and Germany Brought Europe’s Long-Simmering Crisis Back to a Boil

A Game of Chicken Between the Greek Government, Creditors Helped Put Radical-Left Opposition Party Ahead in Polls

The Wall Street Journal

“…the austerity Europe has imposed on Greece as the price of rescue loans…”

“snap elections Sunday, … could return the country to the brink of exit from the euro…”

“Mr. Samaras, a suave conservative who swings between statesmanship and populism…”

“…Wolfgang Schäuble …wanted to boot Greece out of the euro…”

“…Mr. Samaras faced a younger, left-wing version of himself: Syriza leader Alexis Tsipras , who blamed the crisis on austerity, not austerity on the crisis…”

“…Eurozone finance officials now think Greece will need a longer bailout. Sunday’s election winner must bridge an even bigger gap….”

By MARCUS WALKER and  MARIANNA KAKAOUNAKI

Updated Jan. 21, 2015 9:17 p.m. ET

ATHENS—Greek Prime Minister Antonis Samaras, under pressure at home to end his country’s financial bailout regimen, sought help last spring from German Chancellor Angela Merkel about relieving some of Greece’s debt.

Ms. Merkel asked an interpreter to translate the phrase “debt relief,” according to people familiar with the meeting. Then she told Mr. Samaras: “It doesn’t sound as good in German.”

The retort was an early sign Greece could expect little clemency from its German-led creditors.

Greece, the eurozone’s most troubled economy, remains tethered to an unforgiving bailout machinery, built at Berlin’s behest, that issues financial aid in exchange for reforms and regular inspections.

The system’s iron rules helped push the Greek government to snap elections Sunday, with an outcome that could return the country to the brink of exit from the euro. In polls, Mr. Samaras’s ruling conservatives trail the radical-left opposition party Syriza, which promises to end the austerity Europe has imposed on Greece as the price of rescue loans.

Syriza could find it even harder to swallow the market-oriented overhauls that proved too much for Mr. Samaras’s government. Unless it agrees to overhauls, German officials say, Greece won’t get the loans it needs to avoid default by the summer.

Even if Mr. Samaras manages to win Sunday, the mounting conflicts between Athens and its creditors show how hard it will be for any Greek leader to satisfy Europe and the International Monetary Fund without causing political convulsions at home.

Germany’s stringent recipe for making the eurozone more frugal and competitive is putting such pressure on weaker euro members that 2015 threatens to be a year of political upheaval. Across Europe’s depressed South, rising political upstarts such as Syriza and Spain’s left-wing Podemos party are challenging unpopular ruling establishments.

The renewed Greek drama illustrates how Europe’s long economic malaise is increasingly turning into a political and social crisis, eroding public confidence in established parties—and in the institutions of the European Union—while fueling the rise of populists of both left and right.

This account of how Athens and its lenders brought a long-simmering crisis back to a boil is based on interviews with 18 senior officials in Greece, Europe and beyond. Many European officials said Greece was guilty of hubris by trying to end creditors’ control before fixing its economy. But if Mr. Samaras loses Sunday’s elections, Europe’s rigid machinery will have been his nemesis.

“We always tell the crisis countries to ‘Stay the course,’ ” and continue with painful policies if they want to stay in the euro, a senior German official said. “But it’s difficult for them. All we are offering is the stick.”

Mr. Samaras, a suave conservative who swings between statesmanship and populism, used to rail against the tax increases and spending cuts required under Greece’s bailout memorandum with the eurozone and the IMF.

As opposition leader in 2011, Mr. Samaras said the agreement “permanently suffocates the Greek economy.” Rather than blaming the debt crisis for the tough measures, he said: “It’s the memorandum that has bought us closer to bankruptcy.”

But after winning election in June 2012, Mr. Samaras traveled to Berlin to offer Ms. Merkel a mea culpa. He rehearsed his lines with aides for six hours in the Berlin Hilton, then persuaded Ms. Merkel that he would carry out the measures. She backed him, overruling others in Berlin—including her finance minister, Wolfgang Schäuble —who wanted to boot Greece out of the euro.

For nearly two years, Mr. Samaras implemented enough of the bailout requirements to satisfy inspectors from the IMF, the European Commission and the European Central Bank, a group nicknamed the troika. Every positive report won Greece another slice of bailout money. The gaping budget deficit shrank.

But so did Greece’s economy. By early 2014, GDP was 27% smaller than before the financial crisis. Unemployment had reached 28%. Households and businesses had sunk into debt as incomes plunged. A debt crisis that began with government had spread to the private sector. And although recession finally ended, voters had had enough.

The government and European authorities trumpeted Greece’s bond issue in April, the first in four years. Greece had also achieved a small primary surplus: tax revenues covered public spending, excluding debt interest.

But such progress rang hollow to Greeks who paid for it with higher taxes and deep cuts to pay, pensions and health care. “To many ordinary Greeks, the primary surplus means, ‘I am poorer,’ ” said Nick Malkoutzis, founder of MacroPolis.gr, a site of political and economic analysis. “But the hope was that we had staggered over the finish line.”

During European Parliament elections in May, Mr. Samaras faced a younger, left-wing version of himself: Syriza leader Alexis Tsipras , who blamed the crisis on austerity, not austerity on the crisis.

Mr. Samaras, meanwhile, told voters the pain was ending. “There will be no new measures,” he said at a rally in Athens. “No new measures” became his mantra. But under the memorandum, Greece still had to boost its primary surplus to a hefty 4.5% of GDP and hold it there for years.

Syriza came first in the European elections. Lawmakers from Mr. Samaras’s party, New Democracy, made it clear they were tired of passing unpopular measures. The premier shuffled his cabinet, replacing reformist ministers with populists who could take on Syriza.

Mr. Samaras’s priority was to get out of the bailout straitjacket as fast as possible, said people familiar with his thinking. His plan was for Greece to refuse any more bailout loans after 2014, instead relying on bond sales. He sought, at most, an overdraft facility from Europe to assure bond investors.

European inspections would be minimized. The IMF—the troika’s toughest enforcer—would be sent home. Mr. Samaras hoped to declare victory by late 2014. By building political momentum, he could win a tricky vote in the Greek Parliament: The selection of a new Greek president by a February 2015 deadline. The post is ceremonial, but failure to fill it triggers general elections.

For Mr. Samaras’s plan to work, Greece needed to first pass a major troika review that would yield €7.2 billion ($8.3 billion) in aid. The problem was a backlog of overhauls from past reviews, including reforms to taxation, pensions, labor, banks, mortgages, unions, market regulation and the public payroll.

Most officials in Greece’s government wanted to dilute the changes and push the most unpopular reforms into the future. Demands for pension cuts and sales-tax increases, for example, were “political suicide,” a senior Greek official said.

All sides accepted that Greece couldn’t complete all the requirements by year-end. The troika met with Greek officials in Paris in early September to find out how much Greece was willing to do.

During talks at a diplomat’s villa, Greek ministers and aides to Mr. Samaras were deliberately vague “because we were testing the water,” a Greek official said. A top Samaras aide demanded the IMF show respect for Greece’s fiscal improvement. “You can’t treat us as if we’re still in boot camp,” he said.

At night, top officials from both sides dined at a modest bistro near the Arc de Triomphe, after first checking for Greek tourists. The troika proposed more time for the review and extending the bailout into 2015. But that would deny Athens the prize of liberating Greece from the program by Christmas.

The Greeks replied that they wanted no more money from Europe or the IMF after December, when the country would turn to bond markets. The troika was skeptical.

Back at the villa, European Commission negotiator Declan Costello ended the Paris talks by reading aloud the list of overhauls Greece had rejected. “It’s impossible for us to accept your doing nothing on all of these,” he said.

Mr. Samaras then appealed to a higher power. On a Sept. 23 visit to the German chancellery, he asked Ms. Merkel to understand that he couldn’t enact so many unpopular measures during 2014. If Europe pressed Greece too hard, it would find itself dealing with a much less cooperative Syriza government, he warned.

Difficult reforms could be postponed—as so-called leftovers—under a gentler post-bailout agreement that would free Greece from the shackles of the troika.

“We want to declare victory,” Mr. Samaras told the chancellor. “It would be a big success for Europe” if Greece, the hardest-hit crisis country, could graduate from its bailout.

Ms. Merkel asked if bond markets were ready to fund Greece, according to people present. If not, then Greece would need more than overdraft protection from Europe. It would need another bailout.

Ms. Merkel said Greece’s next phase would still require robust inspections—including the IMF. Otherwise, there was no guarantee that Greece would continue with its overhaul. She urged the Greek premier to complete the troika review.

The German side felt Greece was trying to have it both ways. Mr. Samaras was seeking reform delays now—and weak controls later. Berlin suspected Athens was hoping the troika would let it off the hook. German officials advised tackling tough reforms right away. Popular anger would die down, they said.

A trip to Athens by the troika a week later made little headway on the disputed reforms. When Greece’s finance minister, Gikas Hardouvelis, tried to schedule the next meeting, Mr. Costello, of the European Commission, said, “Let’s meet when you’ve made more progress on these points.”

In October, Greece proposed a budget law that infuriated the troika. It would allow many Greeks with tax debts to pay them off in 100 monthly installments. The scheme’s leniency risked undermining already weak habits of paying taxes promptly, troika officials told Athens.

A plunge in Greek bond prices that month scuttled Greece’s chances of raising its own funds. The selloff partly reflected investor suspicions that Greece’s troika review was going badly, as well as fears the government might fall over the presidential vote due by February.

With the troika refusing to return to Athens, officials met again in Paris during November to try to break the deadlock. Greek officials, now worried the review could fail, offered some concessions.

The IMF maintained its demands for tough labor and pension changes. The IMF also wanted extra austerity measures to cover an anticipated budget shortfall from sagging tax revenues.

Greek officials thought the IMF was being stubborn and overly pessimistic. They became convinced the IMF was avoiding an agreement that would pay Greece €7.2 billion, as a hedge against Syriza coming to power.

“You are pulling the rug from under this government,” Chrysanthos Lazaridis, a top aide to Mr. Samaras, told the IMF in Paris. The IMF stays out of politics, was the reply.

The ECB, usually a quiet observer in troika talks, backed the IMF’s view that Greece was doing too little.

Even the European Commission, which showed more sympathy for the political cost of reforms, felt Greece’s concessions on taxes and pensions fell short. The commission thought Greece offered enough to justify another troika visit to Athens, but not enough to close the review. The IMF, meanwhile, didn’t think it was worth the trip.

On Nov. 30, the Greeks, increasingly nervous, emailed new concessions. The proposals, which included higher sales taxes on the economically important hotel sector, caused a public fury following news leaks.

The IMF wanted more. Germany, which had brought the IMF into Europe’s crisis to crack the whip, concluded that Athens didn’t understand: There would be no money for countries that didn’t complete their homework. Even the commission wasn’t satisfied.

“At the end of the day, they had reached the limit of what they could do,” a Brussels-based official said. “And it wasn’t really good enough.”

Mr. Samaras had run out of time to attain the victories he had sought before the Greek Parliament voted on the presidency.

In early December, Mr. Samaras and his closest aides decided the government’s survival now required a roll of the dice. They brought forward the presidential ballot, and postponed a deal with the troika until 2015.

Their gamble was that enough lawmakers would support the government’s nominee for president because, if not, snap elections might sink incumbent lawmakers along with the country.

The gambit failed. Mr. Samaras couldn’t mount an argument that drew broad support. A government that had promised to end the bailout, curtail the measures, expel the IMF, and alleviate the debt had returned empty-handed.

Eurozone finance officials now think Greece will need a longer bailout. Sunday’s election winner must bridge an even bigger gap.

—Gabriele Steinhauser contributed to this article.

Write to Marcus Walker at marcus.walker@wsj.com