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How Greece's Creditors Can Encourage Its Return to Stability



Now that over 75 percent of Greece's debt has been transferred from private banks to the official sector backed by European taxpayers—there is a novel solution to the Greek tragedy that would satisfy the interests of borrowers as well as creditors. This solution could also temper unhelpful nationalism on both sides and doesn't promote future fiscal irresponsibility.

Under this proposal, official creditors and borrowers would enshrine debt stability by setting interest rates equal to nominal growth. Greeks would rejoice. But it would also be necessary and possible to embed strong incentives to discourage Greece from abandoning fiscal responsibility and reform as soon as growth returns. Interest rates would be further adjusted above nominal growth by the amount of a primary deficit and fall below it by the size of the surplus. Creditors would approve.

Any solution to the current impasse must satisfy at least three tests. First, the primary budget surplus required of Greece must not be so large as to inhibit sustainable economic growth. By primary budget surplus we mean revenues less expenditures, excluding interest or debt repayments. This is a better measure of a budget's impact on economic activity than the overall deficit. When the animal spirits are low like now, the multiplier of fiscal conditions on to GDP growth is high. And without GDP growth, there can be no stabilization of the debt-to-GDP ratio.

The European Commission, the European Central Bank, and the International Monetary Fund—the Troika—argue that Greece is on the threshold of positive growth for the first year since 2007, despite its primary budget surpluses. According to Eurostat, Greece achieved a primary budget surplus in 2013 and 2014. Putting aside the current impasse, primary surpluses are scheduled under the existing plan to rise to 4.5 percent by 2016. Hold your nerve and stick to the program, the Troika says.  

But GDP hitting bottom after collapsing by 25 percent is not a sign of success. The lessons of economic history during the 1980s in Latin America  or in Germany during the interwar period, is that paying a foreign tribute on such a scale is inconsistent with economic growth and political stability. The borrowers and others believe the current bailout plan fails the test of long-run viability.

But growth cannot simply be purchased through more borrowing from the same creditors and continuing an unsustainable fiscal policy. The pressure to close the fiscal gap and make reforms cannot be let up. Recall that Greece has required not one but two bailouts—the €110 billion package in 2010 and a further €130 billion accompanied by a bank recapitalization  in 2012. Athens is now seeking a smaller third injection of funds as well as the rewriting of the terms of the first two bailouts. Just as borrowers should not be enslaved to creditors, foreign taxpayers should not be enslaved to debtors. The creditors and others believe Greece's proposals do not pass this test.

Fiscal conservatives fret that an easy solution today would encourage fiscally irresponsible behavior in the future. But it is important to remember that for every excessive borrower there is an excessive lender. Moreover, Greece's current predicament is not a negotiation strategy. It is a human tragedy. Output is down 25 percent, over 100,000 businesses have shut, unemployment has trebled to over 20 percent, with youth unemployment over 60 percent. And those who benefited from the financing and unfunded expenditures in the years preceding 2010—including the international financiers and local oligarchs—are not the ones vulnerable to the cuts in safety nets today.  However, mindful of the moral hazard arguments, access to the special arrangement discussed below should only come about after the kind of haircut experienced by Greece's private sector creditors.

A critical noneconomic test for a sustainable solution is whether it provides room for self-determination. There may be legitimacy to creditors demanding a primary budget surplus target but little to them demanding how a democracy achieves that target. To impose external requirements for Greece to cut its social protection and privatize public assets is asking for trouble. Such a demand would force faulty nationalist prejudices onto an already over sensitive area. Contrary to the average ill-informed opinion, prior to the collapse in Greece's GDP, its public expenditure as a percent of GDP, at around 47 percent, was little different than in Germany or other countries. Except in the case of defense spending, Greece's  allocation between social services and other items is little different too. Greece's fiscal exceptionalism is its poor tax collection. The new government's desire to disrupt the power that undertaxed oligarchs have over the economy and budget, and its determination  to repair social safety nets, are more morally and economically defensible than much of what has been imposed so far in the name of economic reform and European solidarity.

Having purchased all the private sector debt at a deep discount—as has largely occurred—the Troika should reset the interest rate to the percentage level of nominal economic growth, minus the percentage level of primary budget surplus, as calculated by Eurostat. The key to debt stability is for interest rates to be lower than nominal growth. Given that the debt is in official hands, this relationship could be embedded into the formula for setting interest rates rather than hoping for it to come about.

In periods of negative growth there would be a negative interest rate, implying further, modest, resource flow from creditor to debtor. This would not be possible if it were a private sector instrument, but it is appropriate economically if matched by a strong incentive for Greece to run primary budget surpluses when growth returns. This is achieved by the proposed feature that nominal interest rates would be reduced below nominal growth by the amount of the percentage primary surplus or increased by the amount of a primary deficit. Unless Greece runs a significant primary budget surplus when growth returns, nominal interest rates would rise sharply.

Back in 2010 as growth turned sharply negative, interest payments would have dropped further than they did, providing additional room for a less restrictive budget. Given the fiscal multipliers, growth would have arrived earlier. To stop interest rates from rising too rapidly with the return of recovery, the government would be running significant primary surpluses. Under this framework the right discipline is automatically applied at the right time. This is better than a default—the other alternative—and less politicized. There would be no need to welcome the Troika's consuls to the Eleftherios Venizelos airport every month. If this framework had been in place in 2010, Greece would have a lower and declining debt-to-GDP ratio with more growth and less strife.

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