Greece: What should its creditors do now?

Following Sunday’s NO vote in Greece, what ever that might have meant, it is tempting to tell Greece to get lost and be done with them. Aside from the unseemly lack of compassion for our suffering fellow man, the further collapse of the Greek economy and society that would likely follow Grexit (the Greek exit from the Euro and introduction of its own currency) would open unknown and potentially very dangerous risks to the rest of Europe from its southern periphery. However, any new deal between Greece and its creditors should be mutually beneficial for Greece and the EU in the long run and achievable and practical in the short run. What are the key elements needed for such an agreement?

Greece’s second bailout program with its creditors (the EU, ECB, and IMF) expired June 30 after a four-month extension without disbursing the final installment of around $8 billion dollars. It cannot be resurrected. Thus any further discussions between Greece and its creditors will concern a third bailout program.

Greece’s recently replaced and unmissed Finance Minister, Yanis Varoufakis’, stock speech said basically that Greece does not need or want more loans because it is bankrupt rather than illiquid. In short, it wants debt forgiveness. In fact, many European officials have acknowledged the possible need to write off (reduce the present value one way or another of) existing Greek debt but insisted that any such consideration be put off for a new program. Discussion of a new program has now arrived.

The foundation of any financial assistance program with the IMF is its assessment that the borrowing country can repay the loan. This assessment is contained in the IMF’s “Debt Sustainability Analysis.” This analysis imbeds the agreed (or assumed) level of government spending and estimated tax and other government revenue and of the level of economic activity (GDP growth) upon which it depends in a forecasting model of the deficit and debt/GDP ratios expected from implementation of the agreed policies. The IMF was badly embarrassed by its acceptance of overly optimistic assumptions about income growth government revenue in its first bailout program in 2010 with the EU and ECB. Under political pressure from the EU and ECB, these assumptions allowed the IMF to conclude that Greece’s debt would be sustainable thus avoiding the need for some debt write off favored by the IMF but opposed by Germany and France, whose banks held large amounts of that debt. The second bailout program included a write off of about 70% of the privately held Greek debt. However, this came too late and the adjustment in the Greek government’s annual deficits required by the first program proved too severe causing a much larger and longer lasting contraction in the Greek economy than expected and assumed in the IMF Debt Sustainability Analysis at that time.

On June 26, 2015 (i.e. prior to Greece’s default on its $1.7 billion payment to the IMF and to the July 5 referendum) the IMF released a draft Debt Sustainability Analysis based on the information available at that time. It concluded that “If the program had been implemented as assumed, no further debt relief would have been needed under the agreed November 2012 framework…. At the last review in May 2014, Greece’s public debt was assessed to be getting back on a path toward sustainability, though it remained highly vulnerable to shocks. By late summer 2014, with interest rates having declined further, it appeared that no further debt relief would have been needed under the November 2012 framework, if the program were to have been implemented as agreed. But significant changes in policies since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs. Coming on top of the very high existing debt, these new financing needs render the debt dynamics unsustainable…. But if the package of reforms under consideration is weakened further—in particular, through a further lowering of primary surplus targets and even weaker structural reforms—haircuts on debt will become necessary.”

In short, the Greek economy was finally beginning to recover by the end of 2014 but the reversals by the new Syriza government of some of the policies contributing to that gain and the loss of market confidence in the muddled and amateurish behavior of the new government reversed the recovery and further increased Greek deficits. In addition, increasing capital flight has been financed by short-term emergency liquidity loans from the ECB, thus adding to Greece’s over all indebtedness. Capital flight per se should not reduce banks’ capital, as they lose the same amount of assets and liabilities, as long as they are able to liquidate sufficient assets by selling them or by using them as collateral for loans from the ECB or other banks. These loans and the process of transferring Euros abroad are described in the paper I presented in Athens May 19 at the Emergency Economic Summit for Greece: http://works.bepress.com/warren_coats/32/.

Under these circumstances it would be desirable (i.e. consistent with and/or required by a European desire to keep Greece in the Euro Zone while returning it to fiscal balance and sustainability over a reasonable, if somewhat longer, period of time) for Greece’s creditors to forgive some of the debt held by the ECB and IMF and to lower the structural fiscal surpluses initially required in a follow on program for the next few years (this latter element had already been offered by the creditors before the referendum). In short, by reducing Greece’s debt service payments and lowering its primary fiscal surplus, it would endure less “austerity.” Former Finance Minister Varoufakis actually proposed a sensible risk sharing form of refinanced Greek debt indexed to the economy’s economic performance. Creditors would do better than expected on their concessional loans if the economy performed better than forecast and would suffer losses if it did worse. This would give both sides a financial incentive to get the pace and balance of fiscal adjustment right (growth maximizing). While Europe’s political leaders sort out the details, the ECB should continue to provide liquidity credit to the extent that, and as long as, Greek banks can provide realistically valued collateral.

The purpose of these adjustments by the creditors should not and must not be to throw more good money after bad allowing a continuation of decades of corruption, rent seeking and government inefficiency. Long before it joined the Euro Zone, Greece suffered poor government services by a bureaucracy overstaffed by friends and supporters of the government in power at the time. Not receiving expected government services, many Greeks have decided not to pay for what they are not getting. Hence tax evasion and a large underground economy added to Greece’s deficits. Quoting from Bret Stephens’ July 6 column: “Greeks retire earlier and live longer than most of their eurozone peers, which means they spend close to 18% of GDP on public pensions, compared with about 7% in Ireland and 5% in the U.S…. As of 2010, Greek labor costs were 25% higher than in Germany. [As a result of internal devaluation since then, this is no longer true.] A liter of milk in Greece costs 30% more than elsewhere in Europe, thanks to regulations that allow it to remain on the shelf for no more than a week. Pharmaceuticals are also more expensive, thanks to the cartelization of the economy…. Greece wanted to be prosperous without being competitive. It wanted to run a five-star welfare state with a two-star economy. It wanted modernity without efficiency or transparency, and wealth without work. It wanted control over its own destiny—while someone else picked up the check.”

Changing this behavior by Greek governments and the Greek public will not be easy if it is possible at all. The still very strong support by the Greek public for keeping the Euro suggests a strong awareness of the need for some restraints and discipline of its government’s spending. But is the desire for a truly better deal (from their own government) strong enough to overcome the resistance of the entrenched and favored interests, who would lose from liberalizing the economy and cleaning up the patronage mess and tax non compliance, etc.? The best hope is the formation of a unity government that strongly endorses a well balance program of gradual further fiscal adjustment and the continuation of the structural reforms so badly needed. Close monitoring by the creditors of Greek compliance with its promises and the phasing of financial assistance tied to such performance benchmarks, is the IMF’s standard approach to enforcing compliance with the measures the government agrees to. There are risks in agreeing to a third program and risks in not doing so and thus Grexit.

Grexit, even with total default on all external debt, will surely force more austerity on Greece than would any program now contemplated, even before taking account of the almost certain collapse of all of Greece’s already “temporarily” closed banks. The Greek government will hardly be in a position to bailout its banks suffering a surge of non-performing loans. Depositor bail-ins will need to cut all the way into “insured” deposits. The pain will be largely felt only in Greece, and unfortunately mostly by the ordinary Greek citizen.

Emergency Economic Summit for Greece

I just returned from a conference in Athens on the Greek economy. Yanis Varoufakis, Greece’s controversial Finance Minister, gave the (almost) final presentation to the 500 attendees making his usual point that Greece is insolvent not illiquid, meaning that its unsustainable debt should be written off (partially at least). While he is surely correct in that assessment, as usual he failed to discuss or even mention the structural reforms Greece needs to make to improve its productivity and thus lift its standard of living, which are also part of the conditions of the existing assistance program with the IMF/EU/ECB. He wants Greece’s creditors to forgive its debts first with reforms (which the new government says it wants to revers to some extent anyway) to come after. As past Greek behavior has destroyed any trust by its creditors and potential investors, the Troika (IMF/EU/ECB) is unlikely to agree to the Minister’s demands. The highlight of the conference was the critic of the Minister’s remarks by Nobel Prize economist Tom Sargent given immediately after and providing the actual concluding remarks for the day.

Here is an article on the conference that includes a short TV interview that I gave on the side.  http://fnf-europe.org/2015/05/20/fnf-greece-emergency-economic-summit-for-greece-stirs-up-unprecedented-media-coverage/

A video of the full conference and my presentation with be on the Atlas Network website later. https://www.atlasnetwork.org/news/article/how-greece-can-escape-from-economic-crisis?utm_source=AtlasNetwork+World10%3A+Highlights+from+the+global+freedom+movement&utm_campaign=a14b0b99fb-World10_5_6_15&utm_medium=email&utm_term=0_d4bce382cb-a14b0b99fb-26641201

The paper that I prepared for the conference can be found at: http://works.bepress.com/warren_coats/32/

All the best,

WarrenGreece EESG

Saving Greece: Austerity and/or growth

Econ 101: When discussing Greece’s economic problems public officials and the press regularly toss out the need for “austerity” and/or “growth” as if they were clearly defined and understood concepts. I suspect that they mean quite different things to different people. While it is convenient to summarize complicated policies with single words, it can also stand in the way of understanding what is really meant. So what are the policies needed for Greece’s recovery and what should we call them?

Stocks and flows: For starters we need to distinguish the stock of Greek debt (the existing outstanding amount of previous, unrepaid borrowing) from its annual deficit. Greece’s debt reflects the past history of its annual deficits. Its current and prospective deficits foreshadow the future stock of debt. A full default on Greek debt—wiping it all off—would reduce Greece’s annual interest payments on its debt but beyond that would do nothing to reduce its annual deficit and the build up of its future stock of debt, which eventually would again become unsustainable. So forgiving (defaulting on) all existing Greek debt, by itself, will not resolve Greece’s problems.

Sticking with broad simplifications, Greece has two major economic problems. First, its government spends more than it can pay for without borrowing (the deficit — the flow of new debt). Moreover, like the U.S. and many other governments, it has made commitments to spend in the future (e.g. unfunded pension commitments) that are not yet reflected in its stock of debt or its annual deficits. This must change because it is not sustainable. Lenders will lose confidence in the government’s ability to service its debt and will stop lending. This calls for “austerity”, i.e. eliminating the annual deficit, by some combination of reducing expenditures and increasing tax revenue. I will return later to the distinction between structural and cyclical deficits.

Greece’s second major problem is its low productivity and uncompetitive prices. By themselves these would simply imply a lower standard of living for Greeks. But the average Greek has been spending more than his income by borrowing, giving the temporary illusion of a higher standard of living. To the extent that Greek spending is for foreign produced goods and services and these imports are not fully paid for with Greek exports, they must be paid for by borrowing. This artificial standard of living is obviously not sustainable.

Greece shares the same currency, the Euro, with 22 other European countries (including non members such as Monaco, Kosovo, and the Vatican).  If Greeks borrow domestically to pay for imports, Euros will flow out of Greece, tightening liquidity. This should put downward pressure on wages and prices in Greece, which would help restore its competitiveness with the rest of the Euro zone. If Greeks borrow abroad, interest rates on such borrowing should eventually increase to cover the increased default risk. This will discourage Greek borrowing. Greece has reached this point.

Some argue that if Greece had its own currency it could reduce its real wages by devaluing its currency and thus restore external competitiveness. Cutting real wages in this way would be easier, they argue, than cutting nominal wages directly as Greece has just done for government employees. Experience in other countries suggest that devaluing its own currency, if it had one, would set off domestic price increases to offset the loss of real wages unless labor markets were made more competitive. A spiral of devaluations and inflation would likely ensue. Only when real wages can be reduced to competitive levels one way or another can Greece hope to grow out of its current problem.[1] Thus the Greek government is undertaking structural adjustments to liberalize labor and product markets in order to make them more efficient and to make wages and prices more responsive to market conditions.

Some argue that the emphases in Greece should be put on growth.  Given the debate in the U.S. between Keynesian and neo classical economist over whether growth requires “stimulus” to increase demand (the Keynesian view) or “structural adjustments” to make labor and product markets more efficient and to encourage investment (the neoclassical view), it is not completely obvious what the proponents of growth in Greece have in mind. Attempting to promote growth with government stimulus to demand is not in the cards, as that would require more government spending and/or lower taxes and thus even larger deficits that no one is willing to finance. The only way for Greece to enjoy a higher standard of living is to undertake structural reforms that will allow the economy to be more productive and its wages and prices to be more competitive with the rest of the world.

So Greece needs to eliminate its deficits (actually run surpluses to reduce its outstanding debt) and liberalize its labor and product markets to establish balance in its external trade. All serious students of the Greek situation agree with this. The policy debate is complicated, however, by the interaction between growth and deficits and the speed with which an economy adjusts to changes.

If the Greek economy grows more rapidly it helps its debt problem in several ways. First, a growing economy generates more tax revenue from the same tax system. This reduces the deficit. It also tends to reduce government expenditures linked to safety net expenditure (e.g. unemployment insurance). This also reduces the deficit. In addition, the capacity of an economy to sustain and service debt is linked to its size. Thus economists look at the ratio of debt to GDP. A more rapidly growing economy tends to reduce the debt/GDP ratio by increasing the denominator.

While Greece must eliminate its deficits, the initial impact of expenditure cuts and higher taxes is to temporarily reduce income and tax revenue. Greece is experiencing this now. Its expenditure cuts have not reduced its deficit as much as expected because the temporary slow down in economic activity as displaced government employees (for example) look for new jobs, has been larger than expected thus reducing tax revenue by more than expected. A reduction in income has the same but opposite effect on the deficit as does an increase in income. This phenomenon is called automatic stabilization. Both Keynesian and neoclassical economists favor allowing such cyclical swings in government deficits and surpluses. But in the long run the government’s structural deficit (its full employment deficit) should be zero or at least smaller than the economy’s long run average growth rate. In Greece’s case it should be in surplus for a number of years to reduce its existing stock of debt.

The positive impact on competitiveness and income of liberalizing labor, services and product markets will also take time to develop. Balancing Greece’s fiscal budget now, before structural reforms have had time to work, would require much larger fiscal corrections (spending cuts and tax increases) than would be needed for long run balance.

This background should help understand and evaluate Greece’s options. Without external financial help (as is now provided by the EU, IMF and ECB), Greece could not adjust its fiscal deficits enough in the short-term to avoid the need to continue borrowing temporarily. Under these circumstances market lenders are likely to charge such a high risk premium to buy Greek sovereign debt to cover the prospects of default that deficits would become worse rather than better. Greece would default (with or without leaving the Euro). If it had defaulted in December 2011, it would have saved 16.3 billion Euros in interest payments on outstanding debt out of total government expenditures of 76.8 billion, but would have had to cut expenditures instantly an additional 6.3 billion to keep it within its tax revenues of 54.2 billion, over a 10% cut in non-interest expenditures instantaneously. This is austerity on steroids. The Greek economy had already stopped growing in 2008 and shrank by 3.3%, 3.5% and 5.0% in 2009, 10, and 11 respectively. The shock of default would surely depress the real economy further than the 2.0% decline currently forecast for 2012, reducing tax revenue further and requiring even larger cuts in spending. This does not take account of the impact of a Greek default on its banks, which hold a significant amount of Greek sovereign debt, and which the government would no longer be in a position to support. Default is no panacea, and this has not taken into account the possible negative effects in Spain and Italy, to name but two other European countries.

The approach taken by the IMF and EU is to agree with Greece on targets for both deficit reduction (austerity) and structural reforms (growth) that aim to restore full balance by 2021 and to finance the declining deficits in the interim at modest interest rates so that Greece does not need to borrow from the market. The program requires the “voluntary” write down of private sector holdings of Greek sovereign debt by about 70%. Greece would reduce its deficit from almost 10% in 2011 to less than 5% in 2012 (a primary surplus – i.e. not including interest on its debt—of 0.2%, raising to a primary surplus of 2.4% in 2013 and 5.0% in 2014). This “austerity” is being supplemented by significant structural reforms. The program is a balance between the pace of austerity and growth. Slower implementation of austerity requires a longer period of IMF/EU financing but with potentially more rapid growth.

Government employment is being reduced by 22% between 2010 and 2015 (150,000 employees). Future pension commitments have been reduced. Inflation has fallen below the Euro area average. However, external competitiveness has improved as the result of wage reductions in Greece rather than improved productivity, i.e. living standards have fallen. In general, labor market and business sector reforms have lagged. Changes in labor laws to allow more flexible wage bargaining and to ease the cost of lay offs are showing positive results. A number of services and professions have been liberalized to subject them to greater competition (cruise ships, highway freight, tourist coaches, regulated professions). The cost of starting new businesses has been reduced (“The new law reduces the number of steps (from 11 to 1), days (from 38 to 1), and cost (by more than 50 percent) required to start a business.”). Nonetheless the slow pace of such reforms is the major weakness of the program. Public acceptance of its changed circumstances and how best to deal with them has not be easy or smooth either.

It is noteworthy that the Greeks work more hours on average than any other European county (2,017 hours per year compared to 1,408 hours a year for Germans). German’s enjoy a higher standard of living because they produce more each hour they work. Greece needs to liberalize its markets to become more productive. Lowering wages will make Greek output more competitive beyond its borders but will not raise the standard of living for Greek workers.

The euro group has stated in its communiqué, “We reiterate our commitment to provide adequate support to Greece during the life of the program and beyond until it has regained market access provided that Greece fully complies with the requirements and objectives of the adjustment program.” The proviso is standard but also reflects Greece’s poor record of honesty and implementation.

IMF financial support is parceled out in quarterly installments contingent on Greece meeting the conditions agreed to for each quarter. This combines the carrot of financial assistance with the stick of close monitoring of Greece’s compliance with the reforms needed for long run success. There are no good options for Greece, but the current agreement between Greece and the IMF/EU seems to hold out the best hope for potential success. It balances austerity and growth. It will not work without public acceptance. Government promises to its public are being and must be broken. The Government needs to convincingly explain that these promises cannot be kept and that a brighter future requires the reforms that have been promised to the IMF/EU/ECB and the increased productivity and growth they should make possible.

Iceland and Ireland are well on their way to recovery from their debt disasters. If Spain and Italy can get and stay ahead of the adjustment and reform curve, and they have new governments committed to doing so, Europe should pull through and be stronger for the experience. But the next few years will be difficult.


[1] Mario Blejer and Guillermo Ortiz, “Latin Lessons”, The Economist February 18, 2012, page 94.