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A Path Forward for Greece



The people of Greece have spoken, loud and clear, by delivering a resounding victory to Syriza, the left-wing party that won the election last weekend: After suffering five years of economic depression and a massive fiscal tightening (the level of government spending has been cut by 50 percent since 2009), the Greek people cannot stomach any further austerity and have voted for the party that promises change and a different economic policy. The Syriza victory has created a major new dilemma for all of Europe.

It is possible that Syriza, however, in its effort to differentiate itself from the previous government and other establishment parties, may have overplayed its hand during its time in the opposition. By openly committing to renege on existing commitments and demanding debt forgiveness, Syriza may have painted itself into a corner. Beyond the appearances of blackmail and the worries about moral hazard and fairness, it should be clear that the debt relief demanded by Syriza is just not possible at this point. At a time when the euro area is barely starting to see the light at the end of a very long recession, with most euro area countries still undergoing serious fiscal restraint, no parliament in the euro area will be ready to legislate debt forgiveness for Greece while at the same time refusing to increase public sector wages or improve the purchasing power of pensioners for their own citizens. The commentary outside Europe that is calling for debt forgiveness seems to be forgetting the simple fact that after successive rescues of Greece, Greek debt is now mostly in the hands of European taxpayers. Politics always dominates economics.

In addition, debt relief for Greece right now may be unnecessary. The irony of the current turmoil is that, until it became clear that there could be early elections in Greece—and with it a Syriza-led government—markets seemed to be ignoring the debt sustainability issue. Greece's 10-year yields had declined to 5.5 percent last September, and a consensus was building that in 2015 Greece would be able to exit the fiscal adjustment and reform program imposed by the Troika (the European Commission, the European Central Bank, and the International Monetary Fund [IMF]) with just a precautionary credit line, given their recent return to positive GDP growth and the achievement of primary surplus. Fast forward to today, and the contrast is stark: At the time of writing this piece, 10-year yields have reached 10.5 percent, and 5-year credit default swaps (CDSs) are pricing a 70 percent probability of default. The picture is clear: The people of Greece want change, but markets don't seem to trust those who have been elected to bring the change.

Were markets too complacent before? It is always possible. But it is also possible that markets were looking at Greece's debt in a different way. Of Greece's current 175 percent debt-to-GDP ratio, about 100 percentage points is debt owed to European countries via bilateral loans and loans through two special government-backed facilities, the European Financial Stability Fund (EFSF) and the European Stabilization Mechanism (ESM). This debt has a very long average maturity profile, over 25 years, and does no start to be repaid until the next decade. Of the rest, about 30 percentage points are owed to the IMF and to the ECB. In addition, the IMF and ECB would never want to jeopardize their chances of being paid. Most of this debt has a very low interest rate cost. Therefore, from a debt service standpoint, debt in the hands of the private sector is low as a share of GDP and is "senior" to the bulk of the official debt—it comes due well before the official debt. In other words, from the point of view of assessing the value of Greek bonds, the "true" near term debt-to-GDP ratio was just 40 to 50 percent of GDP, in a country expected to run a large primary surplus. Quite manageable, some would say.

This reassuring assessment of Greece's debt situation changed with the elections and the advent of a Syriza-led government. The market turmoil is thus not about the Greek debt outlook but about the Greek political and policy outlook.

There is a potentially intriguing reading of the Greek election outcome: Is it possible that the same people who voted for Syriza are taking their deposits away from the banking sector, just in case they are taxed? Let's not forget Syriza had a tax on deposits in its campaign manifesto. Is it possible that this election outcome was mostly a protest vote against the old establishment, and much less a vote for the policies that Syriza was promoting in its campaign manifesto? Polls seemed to indicate so, and a detailed look at the composition of the new Greek parliament would suggest similarly.

If so, in view of the initial measures proposed by Syriza—such as the restoration of the old wage bargaining system and the suspension of the privatizations—a serious policy mistake could be in the making. The euro area policy mix needs to change by adopting a better mix of demand stimulus and pro-growth reforms, as we have argued in Posen and Ubide (2014). But the Greek government should do what is needed to complete the current program review. (There are well over 10 billion euros pending disbursement for Greece, which would greatly alleviate their near funding outlook.) Greece should thus engage productively with its European partners. The expected primary surplus can certainly be reduced, freeing funds to support growth. The ECB's quantitative easing program, if Greece does what it takes to qualify for it, should boost Greek asset prices later in the year and spur growth. The new Greek government could be an agent of change at the European level, but an open confrontation is not going to deliver any positive outcome.

The next few weeks are going to be critical, given the fragility of the Greek banking sector. The Greek government must understand that some of its radical demands are unrealistic and, more importantly, that the reversal of past policies is not needed to improve the welfare of the Greek people. Most of the actions undertaken in recent years were needed to correct the many mistakes of the past. Bad as these mistakes were, their impact has been exacerbated by Greece's reluctance to deal with entrenched interest groups and by policy mistakes at the European level (such as suggesting that a Greek exit from the euro area was a realistic possibility). These unforced errors have more than offset any positive impact on confidence that the draconian austerity measures could have achieved.

But those are bygones. Revenge never leads to any positive outcome. A further rescheduling of the official debt would make that debt, de facto, nonexistent for a couple of decades from the point of view of debt servicing. Such a step, combined with sound pro-growth policies (both demand stimulus and reforms to boost potential growth), would be enough to restore market confidence, improve the welfare of the Greek people, and allow the new Greek government to chart a credible medium-term path that can attract investment and boost employment. What Greece needs, above all, is growth. The confrontational alternative is a lose-lose situation for Greece, for Europe, and for the world.

Figure 1 Greece 10-year bond yield (percent)

Figure 1

Source: Bloomberg.

Figure 2 Greek sovereign debt by holder (percent of GDP)

Figure 2

ECB = European Central Bank
EFSF = European Financial Stability Facility
ESM = European Stability Mechanism
GGB = Greek Government Bonds
Sources: European Commission, International Monetary Fund, and Bloomberg.

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