Just as it did when Congress recently extended the payroll tax cut, brinkmanship has produced an early morning deal in Europe to extend a new lifeline to Greece and clear the way for the biggest sovereign bond restructuring in history. Both pieces of the agreement—the privately held Greek debt write-down of more than €100 billion and the terms of the new bailout extension—have produced widespread doubts in markets and among many analysts. Accordingly, a more detailed look at both is worthwhile, before considering how this package fits into the ongoing brinkmanship between the euro area and the International Monetary Fund (IMF) and the general focus on austerity in the euro area.
Part 1: The Greek PSI Deal
The agreement on the privately held debt write-down—known as Private Sector Involvement, or PSI—is no ordinary bond swap, but instead a remarkably complex transaction of unprecedented scale. The ultimate haircut accepted by the private creditors from the Institute for International Finance (IIF) went up to 53.5 percent of the principal bond value. Factoring in estimated average reduced coupon payments of new bonds of just 2.63 percent in the first eight years and 3.65 percent of the full 30-year period1, the ultimate net present value (NPV) loss for private creditors looks likely to approach 75 to 80 percent.
The new Greek bonds will be governed by English law, which means that the Greek government will not in the future be able to change the regulation of them. They will also be explicitly treated equally (pari passu) with new official sector loans from the European Financial Stability Facility (EFSF) as part of a co-financing assistance package to Greece. These sweeteners notwithstanding, it remains the case that private creditors face dramatic financial losses as a result of this bond swap.
An important technical aspect of this proposed swap is the proposed issuance of new securities linked to the future GDP of Greece. Investors could this see an increase in bond payments if future Greek growth exceeds currently anticipated levels. This type of bond was used in Argentina after its default and has provided investors with good returns as the Argentinean economy rebounded. The critical question remains what future Greek GDP growth will be. If current GDP growth projections are very low, then there is a reasonably certain future gain for private creditors, although such payouts are capped at "an amount of up to 1 percent of their notional amount" beginning in 2015, according to the Greek Finance Ministry. Figure 1 shows the projected Greek real GDP growth rates (from 2011–20) in the baseline scenario in the most recent IMF Debt Sustainability Analysis (DSA).
Many commentators are likely to dismiss the probability of Greece exiting its recession in 2013 or achieving a 2.3 percent growth rate as early as 2014. As we shall see below, such fears are likely well founded. But in a "baseline scenario" where another Greek default is not assumed, one must heed what my late great colleague and forecaster extraordinaire Mike Mussa called the Zarnowitz Rule: "Deep recessions are typically followed by steep recoveries."
According to the IMF estimates, Greece will suffer a cumulative decline in real GDP of about 16 percent from 2009–12, taking the country to near Latvian recession levels. By any definition, that is a "deep recession." According to the Zarnowitz Rule—named after Victor Zarnowitz, a University of Chicago economics professor who studied business cycles—the projected Greek GDP growth rates after 2013 are extremely conservative, assuming that Greece implements its new IMF reform program. The prospect of Greece not experiencing any noticeable cyclical rebound looks highly implausible in my opinion. The question can be asked: why has the IMF assumed such low future growth rates in its relatively benign baseline scenario?
The IMF may just be extremely wary about Greek growth prospects, which would be understandable. But its caution on growth rates from 2013 to 2020 could also be part of an attempt by the Troika (the European Central Bank (ECB), the European Commission, and the IMF) to "sweeten the PSI deal" by ensuring that any GDP-linked securities will pay out a bit more generously if Greece avoids another default. This prospect could therefore entice more private creditors to sign up for the swap. Euro area leaders would then get the political benefit today of "scalping" private creditors, knowing that the actual pay-outs could increase in the future.
Will private creditors participate in this PSI agreement voluntarily, given the huge losses entailed? No doubt most will, in part because they are subject to "moral suasion" from their own governments, particularly Greece itself when it comes to Greek domestic banks. But whether there will be enough participation from other private holders, including global hedge funds, to ensure a sufficiently large amount of Greece's outstanding privately held debt is voluntarily swapped to sufficiently reduce Greece's total debt burden remains an open question. The alternative is quite clear, as the Greek government has—with the blessing of the euro area and the IMF—already moved to introduce retroactive collective action clauses (CACs) in its outstanding bonds to force holders of Greek law bonds to participate in the "voluntary" swap. The legal route to a coercive restructuring process is thus straightforward. But a coercive restructuring would transform the Greek bond swap into a "credit event," triggering credit default swap contracts.
At this point, however, it is doubtful that doing a coercive Greek restructuring would make a material difference to Greece or the euro area credit markets. Yes, a forced restructuring would trigger credit default swaps. But in today's world of three-year long-term refinancing operations by the ECB, most of Europe's banks have realized the majority of Greek bond losses and limited their gross credit default swap (CDS) exposures (which are spread among many individual banks2), and would probably not suffer major disruptions. No major European bank faces collapse from Greek CDS's. Indeed, actually triggering CDS's on a NPV loss on a sovereign bond of around 75 percent might be preferable to avoid the material impairment of the entire industrialized sovereign CDS market. After all, after such a "voluntary" Greek bond swap, who would believe that any sovereign CDS contract on an Organization for Economic Cooperation and Development (OECD) country would be worth anything? This could ultimately end up hurting legitimate hedging opportunities across sovereign bond markets. In short, it is difficult to see any explanations other than euro area political pride for the extraordinary lengths to which European officials have gone to secure a "voluntary" bond swap.
A more interesting question concerns the fact that this deal affects only private creditors while excluding the entire official sector, e.g., the IMF, the ECB, and euro area governments. Does this arrangement set a new precedent subordinating private sector creditors as junior to the official sector in the euro area? If so, potential contagion to other euro area sovereign bond markets would seem plausible. One could thus question how the IIF could sign on to such a degrading of their status?
The danger of such contagion is far from evident, however. This Greek PSI deal does not necessarily set a precedent for the rest of Europe. The euro area has already declared Greece a unique PSI case, not to be repeated elsewhere. More important, the euro area bond market contagion effects after the first PSI deal was announced in July have abated. Italian and Spanish bond yields are at levels before July, indicating at least some market acceptance. Thus concerns that this week's deal will enshrine private creditor junior status in the euro area appear misguided.
Such is especially the case if Greece cannot ultimately meet its IMF reform commitments and faces a second default down the road. A second post-PSI default would overwhelmingly affect the official sector, since the remaining private sector debt will be highly difficult to restructure under English law. In practical terms, because the IMF is the super-senior creditor, a second Greek default would impose losses predominantly against the other euro area countries. In other words, the current PSI deal merely ensures that severe losses are imposed on private creditors a few months ahead of potentially severe losses for the euro area official sector.
Put against such a counterfactual of an "inevitable second Greek default," it may well have been wise of the IIF to have accepted the de facto "two stage Greek default deal" (first against the private sector and then against the official sector) that was on the table this week and ensure that its private members at least secured new Greek bonds under English law for a part of their original claims. In a hypothetical politically very messy unstructured "single event" Greek default, where losses would have been imposed on both the private and official sector simultaneously, it seems probable that the IIF membership could have faced a consequence even worse than the perhaps 75 percent loss they suffered this week.
Part 2: Greece's New IMF Program Deal
The other part of the deal struck in Brussels concerns a successor IMF program for Greece for at least three years. This new program is premised on Athens's "legal implementation by Greece of the agreed prior actions." There is, for example, a further list of things the Greek parliament must pass in the coming weeks. (The second premise is a successful PSI bond swap reducing Greece's total debt burden.) Considerable uncertainty remains about whether this successor IMF program will ever get off the ground. It looks likely that implementation will take place ahead of Greece's large bond redemption on March 20, however.
The aim of Greece's new IMF program is to reduce Athens' estimated debt/GDP ratio in 2020 to the target of 120.5 percent. It is important to remember, however, that debt/GDP projections eight years into the future are illusory. Such long-term projections are highly dependent on various assumptions. Any eight-year target must be considered a political benchmark, underscoring the fact that it will be up to the Troika to judge whether it has been met.
The euro area governments engaged in a series of financial engineering transactions with the ECB and national central banks to help reach this target. As predicted earlier, the ECB itself will not directly have to take any losses on its Greek bond holdings. But the owners of the ECB—euro area governments—have instead agreed to channel some of the ECB's profits towards Greek debt relief. As they put it, "certain government revenues that emanate from the SMP [Securities Market Program] profits disbursed by NCBs [national central banks] may be allocated by Member States to further improve the sustainability of Greece's public debt."
This statement refers to a complex and circular financial flow, in which the euro area governments will first pay Greece some of its bailout funds, then Greece will pay off the ECB's bonds with this money. Then the ECB pays its profits back to its owners, the euro area governments, which can then grant these funds as debt relief to Greece. The benefits are wholly political, as the arrangement relieves the ECB from direct bond losses. Yet the deal enables the ECB to contribute indirectly to Greek debt sustainability through profits redistributed according to the ECB capital ownership key. This would in theory be done in a manner that Mario Draghi, the ECB president, says does not constitute "monetary financing." National central banks will engage in essentially similar circular transactions.
Of broader significance is the euro area agreement for "an additional retroactive lowering of the interest rates of the Greek Loan Facility so that the margin amounts to 150 basis points." Such a "stealth fiscal transfer" will further reduce Greek interest payments and lower the total debt burden. Moreover, the euro area willingness to continue to trim interest rate costs for Greece suggests that further "stealth measures" may be extended to Ireland and Portugal.
The new IMF debt sustainability analysis (DSA) makes clear that there are real concerns over the prospects for Greek program implementation. The DSA states that Greece's "debt trajectory is extremely sensitive to program delays, suggesting that the program could be accident prone, and calling into question sustainability." Put another way, Greek debt sustainability will not be achieved unless Greek compliance improves materially from the record of omissions and delays since May 2010. Opinion polls suggesting that far-left populist political parties will make gains in the elections due in April, raising doubts about the ability of any new Greek government to implement its commitments.
To ensure greater compliance, some new efforts are under way to install an "enhanced and permanent [Troika] presence on the ground in Greece". Similarly, the separate "escrow account" for Greece will be implemented, as discussed in an earlier post, to "put in place a mechanism that allows better tracing and monitoring of the official borrowing and internally-generated funds destined to service Greece's debt by, under monitoring of the troika, paying an amount corresponding to the coming quarter's debt service directly to a segregated account of Greece's paying agent." In other words, from now on the Troika can pay off Greece's bondholders and withhold funds to the Greek government. Greece's acceptance of the escrow account was possibly the biggest surrender of fiscal sovereignty by any industrialized country in recent history. It reflected the great political lengths Greek leaders are willing to go to avoid an economic default.
Ultimately, however, nothing in the latest developments changes my prediction from early February that the key "euro area political risk" in 2012 remains what to do if Greece turns out to be beyond reform. It seems probable that any new Greek government will get only a brief program honeymoon. If Greece continues its poor record of implementation, the Troika can cut off further bailout funds as soon as a new "euro area firewall" with an operational European Stability Mechanism (ESM) and more capital for the IMF are in place around July. Such a cutoff would set up a potential second Greek default as early as the late summer of this year. The Greek government would then have to decide whether to remain in the euro area. Greece would not likely be kicked out, but a voluntary self-initiated exit would probably be accepted.
It is finally difficult not to interpret the tenor and focus of the latest DSA as almost an invitation to the IMF and its major European shareholders to cut off further funds to Greece. The IMF's non-European shareholders will for reasons of regional resources allocation likely welcome such a step. The IMF staff, of course, will be rightly concerned about the institutional integrity of the IMF in the face of political pressure to give Greece a pass. If the fund were seen to be giving Greece preferential treatment, it would unleash demands for similar leniency from future program recipients around the world.
Part 3: Brinkmanship Between the Euro Area and the IMF
Since December, the EU Council and the IMF have jockeyed over who must pay the bill for a new European financial firewall. Such "burden sharing" was the intent of the euro area's commitment to provide the IMF with about $200 billion in new capital, provided that other members also contribute perhaps $300 billion. Half a trillion dollars in new IMF capital is a lasting global good that would stabilize the euro area. Consequently and appropriately, other major G-20 members have signaled a willingness to provide the IMF with additional new capital, if the euro area does more to save itself. As I have discussed earlier, I continue to believe that EU leaders will agree to increase the ESM to €750 billion at their next summit in early March to accommodate these demands.
At the press conference after the euro group meeting, at which IMF managing director Christine Lagarde also participated, this view was once again reiterated. A possible ESM increase was "considered but not concluded" at that meeting. But Lagarde also invoked brinkmanship yet again in discussing the potential scale of the IMF's participation. German finance minister Wolfgang Schauble mentioned at his press conference that perhaps the fund would contribute an additional €13 billion, plus the remaining €10 billion from the first program, for a total of €23 billion, though this would be subject to the final approval of the IMF Board.
A potential contribution of "only" €23 billion out of a total new program financing need of €130 billion would equal 18 percent, considerably less than the hitherto implemented one-third/two-thirds split between the IMF and the euro area. But an important caveat must be kept in mind. The €130 billion total includes several idiosyncratic components, with which IMF contributors will not participate. (These include the costs associated with providing EFSF financial support for the Greek PSI deal and associated bank recapitalizations, and projected future Greek ESM contributions.) Stripping the new Greek IMF program of "euro area specific financing items," elevates the €23 billion IMF contribution to the traditional participation level of about a third of the total.
Lagarde fired a little-noticed warning shot, however, when she stated that "the IMF board will have in mind the overall program but also additional matters such as the proper setting up of a decent firewall comprising of EFSF and ESM as considered today, but not concluded today." She also made it clear that the IMF Board would decide on its contribution only in the second week of March after the next EU Summit.
In other words, unless EU leaders agree to increase the ESM, other G-20 members will likely not contribute more money and the IMF Board might even decide to reduce the fund's participation in the future, forcing the euro area governments to make up the shortfall. Exercising brinkmanship in her own fashion, Lagarde presented a choice to EU leaders and Chancellor Angela Merkel of Germany in particular: pour more money into the ESM in early March or be forced to pour them into Greece later.
No doubt EU leaders will choose the former.
Part 4: Austerity in the Euro Area
The deteriorating situation in Greece is frequently cited as an example of the adverse economic impact of Europe's insistence on austerity. Athens is alleged to be an example of a wrong-headed European crisis response, with its tough new Fiscal Pact and other rules to enhance surveillance and budgetary discipline within the common area membership. This critique, however, is only partly deserved. It ironically suffers from the same fetishistic preoccupation with austerity that it criticizes.
No doubt austerity hurts short-term growth prospects and the doctrine of "expansionary consolidation" is a politically expedient myth without empirical foundation. But short-term austerity is not the only economic and political problem troubling Greece or the rest of the European periphery. Each crisis- stricken economy (as well as most of the rest of the euro area, noticeably France) faces its own idiosyncratic and complex structural barriers to growth. The euro area's short-term growth picture and outlook (-0.3 percent real GDP growth in Q4 2011) is not great, but the real growth disaster for Europe is the continent's low long-term potential growth rate, for which estimates since the beginning of the global financial crisis have fallen below 1 percent. That is less than half the estimated potential growth rate before the crisis began. Substantial empirical uncertainty surrounds such estimates, yet without far-reaching structural reforms, the euro area crisis will pose a long term threat to the potential growth rate of the euro area economy far greater than the short-term slump of the next several quarters.
In the ideal world, farsighted policymakers could simultaneously pursue short growth through fiscal stimulus and structurally overhaul their economy for the long-term and restore fiscal sustainability when growth returns. But such a political feat is impossible in a crisis with the unprecedented fiscal and banking turmoil in the euro area today. Elected leaders have a finite agenda at any one moment and must consequently sequence their responses.
Ultimately the right policy emphasis will vary from economy to economy. For the United States, which continues to suffer from a cyclical downturn, more short-term economic stimulus is warranted. Again in an ideal world, Congress would pay for such stimulus (and other federal government spending programs and defense) in a sustainable manner.
The euro area periphery is in a different situation, however. Current estimated trend GDP growth rates in the five countries are less than 1 percent.4 Spain will never see sustained job growth with its current labor market laws. Other euro area countries with average effective retirement ages of around 60,5 or the majority of workers protected from adjustments to their work rules and conditions, will never regain competitiveness without change. Indeed absent such structural reforms, new fiscal stimulus in the euro area periphery will be a waste.
Proponents of steps to reflate the euro area periphery miss the critical political economy point. Structural reforms are the most politically difficult steps to implement for incumbent governments. They are adopted by parliaments only when all other options are exhausted. As the euro area crisis illustrates, the boundaries of what is politically possible are expanded only when the pressure is most acute. Fiscally stimulating these troubled economies before appropriate structural reforms are implemented would be a mistake.
Some paint current euro area austerity as needlessly flagellating medicine meted out by a moralistic "pain caucus." They overlook the fact that the euro area is finally embarking on critically important structural reforms. Spain's labor markets are being reformed, and Italy's closed services sectors are finally seeing some sunlight.
This sequencing is not an accident. Neither Spain nor Italy would be undertaking reform without accepting austerity first. The austerity measures were a necessary political evil on the road to the hardest structural adjustments. The fact that progress is under way across almost all the periphery is among the best news coming out of Europe. These steps forward have consigned Greece to the role of an inglorious outlier, deserving of more blame for its failure to implement structural changes than for missing its deficit targets. On the other hand, it is important to give some "policy space" to countries undertaking reform, enabling them to fall short of their deficit targets if they are embarking on a healthy long-term political agenda. It would not be responsible to punish such hard-won successes in these countries.
Fortunately, Europe's new Fiscal Compact has more than enough political room to grant genuine euro area structural reformers some leniency on reaching deficit targets. The Troika and the European Commission for non-IMF program countries must use that latitude responsibly. A country that has implemented the structural components of its IMF program for instance should always be considered to be in "political compliance" with its program, irrespective of whether it misses its annual deficit target be a little bit.
Prime Minister Mario Monti is right that an Italy that has now embarked on a serious set of structural reforms should not implement additional austerity measures. It would be madness if the European Commission were to insist that the Spanish government—busy with overhauling its labor markets and banking system—meet its 4.4 percent of GDP deficit target for 2012.
Credible structural reformers in Italy, Spain, and Portugal should be granted the benefit of the doubt on their 2012 deficits by the IMF and—especially—the European Commission. Otherwise, Europe's fiscal surveillance framework will not have progressed during this crisis.
1. All data from the Steering Committee of the Private Creditor-Investor Committee for Greece Press Release "Common Understanding Reached on Key Terms of a Voluntary Exchange of Privately Held Greek Government Bonds (GGB's)," dated February 21, 2012.
5. The standard OECD measure for average effective age of retirement is available here and is calculated as a weighted average of (net) withdrawals from the labor market at different ages over a 5-year period for workers initially aged 40 and over. In order to abstract from compositional effects in the age structure of the population, labor force withdrawals are estimated based on changes in labor force participation rates rather than labor force levels. These changes are calculated for each (synthetic) cohort divided into 5-year age groups.