Greece: Incremental Solutions Will Not Work

 by Ajai Chopra

The impasse between Greece’s new government and the rest of the euro area arose from bad policy decisions made in 2010. Numerous commentators warned at the time that Greece was insolvent and that debt restructuring or default was inevitable. Among these was the Peterson Institute’s Jacob Funk Kirkegaard, who in May 2010 pointed out that the rescue package for Greece designed and administered by the European Commission, the European Central Bank, and the International Monetary Fund (IMF)—the so-called Troika—was “just not credible” and that the country’s debt burden would need to be lowered. (For a list of commentators making this point see paragraph 56 of the IMF’s 2013 evaluation [pdf] of its involvement in the program for Greece.)

Instead of recognizing that Greece’s debt burden was unsustainable and negotiating a deep debt restructuring at the outset, the euro area and the IMF decided to bail out Greece’s private creditors, who held most of its debt. That is, public money was lent to Greece and this money was used to repay maturing private debt, which was held primarily by French and German banks. Creditors, whose profligacy had matched that of the Greeks, were allowed to cash out rather than face the consequences of their bad decisions, perpetuating moral hazard on the part of the lenders. The bill was imposed on Greek taxpayers, and the Troika required Greece to undertake massive fiscal tightening, which contributed to an economic depression and made it more difficult to implement the reforms needed to improve the functioning of Greece’s distorted economy.

A dictum of crisis management is to recognize past mistakes, identify and allocate the losses equitably, and move on. This dictum was ignored at the outset and continues to be ignored. Rather, what Ashoka Mody calls “driblets of relief,” reductions in interest rates and the extension of repayment maturities for most official loans, have “served only to prolong Greece’s struggles.” As a result, the Greek crisis continues to roil the euro area, with hostile political consequences and substantial economic costs.

What if Greece had been allowed to restructure its sovereign debt in 2010 and creditor governments had then swiftly recapitalized the affected banks if they were not able to raise private capital to cover losses? What if the burden had been shared by creditors rather than being imposed primarily on taxpayers in Greece? How would things in Europe look today? Most likely quite a bit better than it looks now, with a smaller final bill for the official sector and stronger economic prospects.

The lesson from the last five years of turmoil in Greece is that incremental solutions, even though politically expedient, will not resolve the crisis and that delays are costly. Official creditors and the Greek government now need to work toward a sustainable long-term solution. On both sides, brinksmanship that could result in an accident that leads to Greece being forced out of the euro area, with disastrous consequences for all, must be avoided.

The sustainable long-term solution should generate economic growth, reduce deflationary pressure, and create conditions for a return to market access for Greece, rather than perpetuate reliance on official financing. The following elements will be central for such a solution.

First, a further sizeable reduction in Greece’s debt burden in net present value terms is essential, undertaken in a permanent way that largely eliminates long-term uncertainty and makes private investors more willing to return to Greece. As IMF loans have short maturities and high interest surcharges, the IMF should persuade euro area governments to replace these obligations with cheaper and longer maturity loans from the European Stability Mechanism, which did not exist when the IMF joined the Troika arrangement.

Second, Greece has succeeded in achieving a primary surplus (that is, a budget surplus excluding interest payments), but the continued harsh fiscal tightening to increase this surplus—to 4 1/2 percent of GDP as projected by the Troika—needs to stop. The suggested permanent reduction in the debt burden would create space for less tight fiscal policy while still aiming to generate a small primary surplus.

Third, Greece must implement reforms to strengthen fiscal institutions and public administration and to reduce distortions that inhibit the country’s productive capacity. The reduced burden of public debt and the additional fiscal space will make the policies to address the economy’s structural deficiencies more acceptable to the restive Greek public.

Concessions by both sides can yield a result beneficial to all parties. But if instead creditors—that is, euro area taxpayers—insist that Greece abide by previous agreements, they will be condemning Greece and the euro area itself to suffer repeated turmoil.