Two Lessons from the Greek Crisis

(da voxeu )
The new rescue plan for Greece signed in Brussels last week and accepted today by private investors combines “new money” (130 billion from the EU and the IMF) with “debt forgiveness”. Private holders of the 177 billion Greek debt issued under Greek law (out of 206 billion of private debt) will take a 53.5 percent haircut on the debt’s nominal value, with the remaining 46.5 per cent will be swapped for cash (15 percent) and for new longer term Greek debt (31.5 per cent), with an estimated present value cut of 75 percent. This is good news, in the sense that a messy default will be avoided and that the European tax payers will not be the only one to carry the burden of banks’ bad loans. Yet, as pointed out by few observers (1), the direct Official Sector Involvement is also going to be considerable: the estimated 100 billion of total debt relief imposed on private creditors will be partly offset by the new 130 billion official money, which will go largely to private investors (15 billion in EFSF guarantees and about 30 billion for banks recapitalization). And this comes after a considerable “restructuring” of official debt (maturity extension and interest reduction) has already happened.

The new package, despite its the emphasis on stronger enforcement (the permanent monitoring of the “troika” EU-IMF- BCE, the escrow account) will not put an end to the Greek saga. Even in the favorable scenario where the plan would achieve its objective of reducing the Greek debt-GDP ratio to 120 percent by 2020, it would leave more about three quarters of the remaining Greek debts in public hands, so that new issues would become effectively junior debt. Moreover, in the unlikely case that it were successful in restoring the country’s market access, such a level of indebtedness would leave Greece extremely vulnerable to changes in risk attitudes. The “grey” (virtual) market prices of the new swapped bonds put them in the range 22-17 cents to the Euro, implying a similar default risk as the asset they replace. Compared to their book values, therefore, private investors have made quite a good bargain.
More generally, there are two lessons we can learn from the way the EU has dealt with Greece.

Greece: GDP Growth and the Debt/GDP ratio
  • Delay is costly. The logic behind “debt forgiveness” is that investors may realize that the debtor country will not be able or/and be willing to repay, because at such a level of indebtedness, the benefits from the debtor painful adjustment will only marginally accrue to himself. Thus by forgiving part of the debt creditors may actually enhance repayments by providing the right incentives to debtors. Clearly, a restructuring agreement should be reached as soon as possible, not after the debtor’s economy has been shattered by the measures imposed by creditors. With Greece, it took about four years to reach the agreement: the harsh adjustment led to a sharp contraction in the economy’s growth (red line, left scale in the figure below) and to the explosion of the debt burden (blue line, right scale), while the ambitious targets were never fully met. So why wasn’t an agreement reached at the outset ? In short it was Europe’s fault. 
  • “More Europe” is (not) the solution. We heard it , over and over: “since the crisis is European, the solution must be “more Europe””. The consequences of this ill-conceived idea are for everyone to see. Instead of choosing a realistic option of increasing the IMF’s endowment and let it deal with troubled EU countries, Europeans decided to create new ad-hoc institutions (EFSF, the ESM). With insufficient funding, clumsy voting rules (requiring in some cases unanimity), a payment system “by installments” possibly propagating contagion (see my article on, the new institutions achieved the following little enviable results:
– they made technical decisions the hostage of national politics (German state and French general elections, German Constitutional Court pronouncements, Finnish government coalitions, approvals of national parliaments, a referendum in Ireland);
– they introduced dangerous conflicts of interest within-countries, opposing tax payers’ and banks’ interests on the one hand, and between European countries, the creditors against and debtors. This made national governments positions erratic and uncertain (e.g. Germany). The result was a much delayed restructuring and heightened contagion risk.

Economist know all too well that if an institutional setting A (say a unified EU-wide budget) is preferable to a another, B (say the current system of national budgets), a marginal reform of B towards A (such as the EFSF , the “fiscal compact”, or the “Eurobonds”) may actually reduce welfare. The typical example is labor market institutions (2). Both a decentralized and a fully-centralized system of wage bargaining may outperform an intermediate system in achieving wage moderation and low unemployment: the first by making the country-wide union internalize the macro implication of wage setting; the second by generating competition between local unions. Very often the worst lies in the middle. The newly-created EU institutions fit the picture: Germany does not internalize the positive EU-wide externalities of its choices, so that institutions’ funding is sub-optimal and markets are not re-assured; Greece does not bear the full responsibility of its actions, so that the adjustment is delayed.

Unrolling and dismantling or fixing the new institutions is not going to be politically easier than jumping to a fully fledged political union. Thus the EU Zone will linger on, despite PSI, keeping its finger crossed that larger countries such as Italy and Spain will bootstrap themselves out of the debt crisis.

(1) Nouriel Roubini,2012, “A Sweet Greek PSI Deal Transfers the Bulk of Future Losses to the Official Sector,
(2) see Calmfors and Driffill, Centralizazion of Wage Bargaining, Economic Policy, April, 1988