Discourse in the financial press and among officials involved in assisting Greece in recent weeks has focused on the merits, mechanics and modalities of private sector involvement in a new Greek aid package. The question has been whether the holders of Greek government bonds should accept an extension of maturity or some other form of restructuring. Greece's domestic politics and its conflict with the creditor countries, principally Germany, are now threatening to greatly complicate international negotiations.
Imposing large losses in present-value terms on Greece's creditors could panic the financial markets and entail losses for European banks. Thus it is tempting to try once again to "kick the can down the road," by offering loans from official institutions, particularly the European Central Bank (ECB), the euro area, and the International Monetary Fund (IMF). The hope is that by doing so, financial losses can be deferred until the overall European economic situation has improved, banks have strengthened their capital base, and investors have discounted their bond holdings or sloughed them off to holders who are more able to sustain losses (including the public sector). This approach has sometimes been successful in the past.
There are at least two problems with this strategy, however. First, when debt is not credibly sustainable in the long run, private markets will tend to telescope the future back to the present (by denying new financing and raising risk premia) and authorities must engage in a continuous effort to persuade the markets that losses can be avoided. Given the vagaries of euro area governance and politics, this is a difficult act of persuasion, to say the least.
Second, and perhaps more fundamentally, kicking the can down the road risks austerity fatigue. At the onset of a crisis, governments might call upon their supporters and the opposition to make large economic sacrifices for the good of the country and to avoid default. Indeed, the governments of Greece, Ireland, and Portugal have been successful in making this case. But the domestic political argument for austerity is that, unpleasant as it is, that course is better than the alternative and will ultimately lead to a better future. When Plan A doesn't work, as Greece's May 2010 rescue has proven to be insufficient, the government's (the euro area's and the international community's) credibility is damaged and persuading the country that a second round of sacrifice is necessary as part of Plan B is a hard sell. Opponents will predictably ask: "What's next, Plan C?" Never mind that failure to implement the full set of adjustment measures is part of the reason for the failure of Plan A in the first place and that the new package calls in substantial measure for following through on the original program (as in the case of privatization of Greek government assets); the political window of opportunity for adopting sacrifices has closed. It is one thing to ask voters, legislators and political parties to support austerity when the impact of the crisis is barely felt; it is quite another to ask for new punishment when the pain has already become excruciating. When asking for deep cuts in wages, government employment and social programs, governments better get it right the first time.
Discussions about the mix of adjustment, official financing and creditor haircuts are of course fundamentally important. Questions about the voluntary and involuntary nature of restructuring, the instruments by which the haircut is applied, the response of the credit rating agencies, regulatory forbearance in marking losses to market, and the collateral policies of the ECB – all are similarly critical. But these debates increasingly appear to be over the distribution of the losses; domestic politics in Greece are determining the amount of losses to be distributed and the likely timing of their realization.
Restructuring debt on a "voluntary" basis requires persuading creditors that they are better off with an orderly debt exchange than a chaotic default. Creditors assess the risk in large measure by reading the domestic political tea leaves. With the German Bundestag and finance minister insisting on private sector involvement, and with Greek opposition to austerity growing, investors are naturally factoring in a greater probability of large losses on Greek government bonds. Domestic politics, more than the relatively technical issues surrounding "reprofiling" recently debated by officials, is likely to determine whether restructuring is relatively attractive to investors. Whether Greek Prime Minister George Papandreou survives a vote of confidence and succeeds in passing the new policy package will be fundamental. Depending on the outcome, private creditors might decide that the haircut that might have been available to them a short while ago was a bargain by comparison.
Niall Ferguson recently paraphrased Milton Friedman by remarking that defaults are "always and everywhere a political phenomenon." The economics of debt sustainability provide a crucial context; but how the debt is accumulated and whether it is serviced and repaid are ultimately political decisions. This will be true of Greece as of other countries.