A Bad Eurogroup Decision on Greeceby Anders Aslund | February 24th, 2012 | 02:48 pm
Two years after the acute financial crisis erupted in Greece, the Eurogroup, the European Central Bank (ECB), and the International Monetary Fund (IMF) are still trying to get a handle on the problem. Their latest failure occurred after another all-night mangling on February 21. In fact, what they achieved was a Greek default, although it is called a “Private Sector Involvement” (PSI) and declared voluntary. But how voluntary is it when the nominal write-off is 53.5 percent and the real write-off is 75 percent because of reduced yields on the replacement bonds? There are at least ten reasons why this agreement is wrong.
1. The fundamental failure is that the Greece is left with an unbearable debt burden. If a default was considered necessary, it had to be sufficiently large, as Lee Buchheit of Cleary, Gottlieb, Steen, and Hamilton has taught us. It should reduce the public debt to no more than 60 to 90 percent of GDP. The troika (consisting of the IMF, the ECB, and the European Commission) merely reduced it to 120 percent of GDP in 2020, though the IMF assesses that the public debt burden will remain 129 percent of GDP in 2020. As the IMF states in its preliminary debt sustainability analysis: “The results point to a need for additional debt relief from the official or private sectors to bring the debt trajectory down.” Martin Wolf wrote in the Financial Times on February 15: “It is near certain then that more debt reduction will be needed.” Thus, this program lacks all credibility, which is harmful in itself. Greece will have to do another default. This debt restructuring has not solved Greece’s problem but caused more damage.
2. Politically, the tension between Greece and the rest of the European Union may grow so bad that the sustainability of the European Union comes into question. With an overwhelming public debt, the Greek people will struggle with a large debt service for at least a decade, which is demoralizing and humiliating. The maintenance of that large public debt means that other countries’ public sectors will replace previous private creditors on an increasing scale. The taxpayers in the countries concerned will be annoyed. The donor countries—Germany, the Netherlands, and Finland—have had it. They face an impossible dilemma. Either they pose too many conditions, or they provide too little assistance, or they lose their credit rating. In either case, they aggravate their relationship with Greece. Given the realities, relations with Greece should be minimized for the sake of future friendship. The necessary confidence for large-scale assistance is absent. As a consequence, the relations between Greece and the EU creditor countries are not likely to improve, but to deteriorate until Greece has reduced its debt further.
3. The blame for this failure to accomplish a sufficient debt reduction rests with the ECB and the euro group. Everybody but private bondholders is now treated as equally privileged as the IMF, the ECB, the European Union, and EU governments. This is a new and very unfortunate precedent. Nor should such a principle be established in this fashion. Tellingly, the IMF in the quote above suggested additional debt relief from the “official” sector.
4. Perhaps the most galling is that the ECB, which has bought Greek government bonds cheaply for a market value of €40 billion with a face value of €55 billion, will now make a net profit of €15 billion! Rather than sharing its windfall gain with the suffering Greek population or private bondholders, the ECB wants to distribute it to the national central banks, apparently realizing that it has done something morally unacceptable.
5. As a consequence of this novel debt restructuring, which gives privileges to all official creditors, sovereign bonds will lose much of their attraction to private buyers. Other countries in danger, notably Portugal, could be hurt and then the contagion could proliferate. Not surprisingly, the Portuguese ten-year yield rose significantly (by 18 basis points) on the very day this deal was announced.
6. A corollary is that whenever the ECB purchases sovereign bonds which are in peril, that should be a sell signal to private bondholders in the future and thus counterproductive. This may mean that the ECB’s ability to pursue quantitative easing is severely constrained and its range of effective actions will be reduced.
7. Another casualty is the Institute of International Finance (IIF), which negotiated the deal on behalf of the private sector. It appears to have discredited itself completely in its relations with private bondholders by delivering the worst possible result. Ultimately it is the IIF that accepted that everybody but private bondholders was privileged. If this becomes an accepted precedent, the IIF has done permanent damage.
8. Greece is a high income country with a GDP per capita in 2010 of $28,000, leaving it as the 30th richest country in the world right in the middle of the European Union, richer than 12 poorer EU countries. It is morally objectionable that Greece, which has traditionally been the greatest beneficiary of EU grants, should receive vast amounts of international assistance, not only from much poorer EU members but also from developing countries through the IMF. Long-lasting overconsumption must not be a basis for international assistance.
9. The Greek program of 2010 was all wrong. It was never realistic or financially sustainable, which detracts from the IMF’s credibility. It contained more tax hikes than expenditure cuts, and it contained no growth-promoting deregulation or other structural reforms. It did not even trim the bureaucracy in numbers. Since most EU countries already have undertaken these reforms, Greece only needs to look at its neighbors. But this should be left to the Greeks to do.
10. Specifically, it makes no sense for the IMF and the European Union to assume responsibility for a cut in the minimum wage of 22 percent, while top civil service salaries and parliamentarians are left almost untouched. The Greek government will have to be responsible for reasonable equity in front of its voters.
So what should have been done instead?
1. First, the Greek default should be big enough so that the country’s debt burden becomes manageable in the future. My preference would be a public debt reduction to 60 percent of GDP. The ECB and EU holdings should be hit as badly as private bond holdings, and the ECB should not be allowed to profit from the default. It is easier for official creditors to accept losses for sunken costs of an obvious disaster in Greece than to be asked to contribute more for dubious ends all the time. But after having taken these big hits, the ECB, the European Union, and the IMF would not have to contribute much more.
2. Greece has just reached primary balance—that is, its public expenditures and revenues are in balance if debt service is ignored. That is the right time to carry out a default.
3. There is no reason to exclude Greece from the euro area, which would cause major financial disruption and great damage to all. Instead, the ECB and the euro group should allow Greece its necessary default within the euro area and make sure that the payments system continues to function.
4. After a default, Greece would have to live largely on its own means, and take responsibility for its own policies. A popular slapstick has become that Greece shows that austerity does not work, while the reality is that Greece shows that long-lasting borrowing and rent-seeking for the sake of overconsumption do not work. Greece has become quite a wealthy country on the back of unprecedented European Union grants and additional public borrowing. This is the time to stop this international misbehavior, while also stopping the domestic malfunction, which has resulted in excessive public expenditures, exorbitant benefits for the public sector elite, and excessive budget deficits and public debt.
5. These are all reasons to let the Greek democracy handle as much as possible of this hard fiscal policy on its own. The combination of unilateral default and minimal direct foreign assistance may best facilitate a reasonable solution. Greece needs a catharsis. Russia after the financial crash of 1998 comes to mind. After foreign assistance had failed to make an impact, the shock of default made the Russian government do what was necessary.
The European Union will have to revisit its bad decision of February 21 on the Greek crisis. The earlier it does so, the less the cost will be. The euro area needs to broaden the default but keep it amicable and to keep Greece within its membership. The trick is to treat the ECB, the European Union, and EU countries as private bondholders and make their own sacrifice deeper. The European Union should take more costs of the Greek crisis as defaults on bonds and offer less as assistance, or to be more specific as loans.
So far, Greece looks more like Argentina in 2000 (we have not yet reached 2001) than Russia in 1998.