Sunday, October 03, 2010

Should Greece Default?

On my last trip to Greece, no question came up more than, "if this is success, then what does failure look like?" The government and the "troika" say the program is off to a great start and the numbers are more or less in line with forecasts (save a few billion here and there). However, households are squeezed by inflation, wage cuts, and illiquidity, while many people face or fear unemployment. Households are barely getting by. If this is what avoiding default looks like, why not default? 

Few outsiders think Greece should not default and even they do so because they fear "contagion" or want to show "unity," rather than because Greece is solvent. For the pro-default camp, the bailout is throwing good money after bad money. Nouriel Roubini argues that "Greece is not just suffering from a liquidity crisis; it is facing an insolvency crisis too." If Greece is indeed insolvent, a bailout without debt restructuring is useless. Jeffrey Miron, meanwhile, argues that "a bailout will not address the fundamental causes of Greece's fiscal problems."

The broader question is not whether Greece should default, but whether the path to a sustainable economic future is aided or not by default. In other words, does default help Greece get to where it wants to be? Who knows whether the Greek government seriously considered default - did it weigh the pros and cons or did it consider default a non-starter? Hard to tell. But looking at the case for the default, there are several drawbacks worth making.

First, the most obvious gain, which is that default frees up money: if Greece stopped paying down debt, spending could be redirected to other uses. According to the IMF, the Greek state is going to spend €13 bn on interest payments in 2010 or 5.6% of GDP. For 2011, the projection is €15.2 bn or 6.5% of GDP. What if the Greek government did not have to pay this money? In 2010 and 2011, Greece faces a deficit in its primary balance - even without interest payments, the Greek state is spending more than it is receiving. So it needs to borrow (in this case from the troika), even assuming that it had to spend no money on interest.

The IMF projects a primary (pre-interest) deficit of 2.2% in 2010 and 0.8% in 2011. Assuming that default means no access to capital markets, the Greek adjustment in 2010 and 2011 would have been 2.2% and 0.8% of GDP higher, respectively. So if Greece did not pay interest but lost access to capital markets, it would have to cut spending or raise money taxes more than it is currently doing. Meanwhile, the liquidity crunch would have been much greater.

This is obviously just 2010 and 2011. I am mindful that the long-term economic costs of default are not as great as many people fear (see here); but even the short-term analysis shows that the adjustment under a default scenario would have been much than under the bailout plan. Not until 2012 would Greece have been able to make smaller sacrifices than it is currently making if it had chosen default.

Second, default, if accompanied with a currency re-launch, would alleviate fears that Greece cannot really adjust while in the euro. What Greece needs, acceding to this view, is to re-introduce the drachma, devalue and regain competitiveness. Greece does in fact need to make a serious internal adjustment. From 2001 to 2009, Greece's inflation rate was more than 50% the euro average - prices and wages rose disproportionately and so they need to come down disproportionately. The IMF notes that Greece's inflation - excluding the one-off rise in prices due to the tax hikes - is already below the euro average. Remaining on this path will be hard.

There is a broader issue, however: people place a lot of faith on the exchange rate as the way to be competitive. They assume that with a drachma, Greek goods and services would be competitive again and the economy would grow faster. Problem is we did have a drachma and we still ran current account deficits. A currency-only export strategy competes on price alone; price un-competitiveness in Greece reflects deeper structural issues such as the lack of internal competition and innovation. An undervalued exchange rate would provide temporary reprieve without resolving structural distortions.

Finally, there is finally the question of solvency: if Greece is insolvent, should it not restructure its debts and get on with its life? The problem here is that solvency is a tricky concept. In "This Time is Different," Carmen Reinhard and Kenneth Rogoff chronicle 36 external default episodes for middle income countries that took place from 1970 to 2008. More than half of those episodes included default when external debt was below 60% of GDP. In only 16% of the cases did external debt exceed 100%.

Greece's total public debt is expected to hit 130% of GDP in 2010, which is clearly very high. In fact, according to the numbers above, Greece should have reached insolvency sometime in the 1990s. So whether it is sustainable is a different question altogether. Whether Greece can avoid default depends very much on the mood of the markets circa 2012, when it needs to borrow again. If markets are euphoric, they will lend to Greece anyway; if they are jittery, they would attach a high premium regardless of whether Greece's debt level is 144% or 150% or 155% of GDP. This is not to deny the obvious - that more debt is worse - but to qualify the usefulness of that statement in assessing solvency.

Now, this is just economics. It is worth going back to Jeffrey Miron's point - he has touched on the right issue but gotten it completely wrong in my mind. If the Greek government had defaulted, would it have been more or less able to carry out reform? This is like asking, what does the Greek political scene look like if Greece chose default?

The first point to make here is that the "troika" has been a catalyst for reform on three levels. First, there is a consistent pressure to keep reform moving (at least so far) and thus avoid reform fatigue. There is also a pressure to not give in to protestors. It will be interesting to see how the "troika" responds to the first bumps. One of the lessons that the IMF drew from its engagement with Argentina is that the IMF team was too timid in speaking out forcefully when Argentina pursued bad policies. IMF experts were overruled by the IMF politicians. If the pressure on Greece continues - and there seems to be little patience in Europe to let Greece off easily - that would be great for reform.

Second, the presence of the "troika" has realigned Greek politics. Reform is decided between the Greek government and the "troika" with Greek society and interest groups being informed of the outcome rather than asked to participate. At this stage, most proposals have a "de facto" feel to them - they will pass whether you like it or not. This obviously sounds very undemocratic and it is. But if one considers what the alternative is - "democracy" meaning little more than caving to interest groups and prolonging disastrous policies - then good riddance.

Third, Greece is getting a lot of technical support. Greece's challenge is not just political but also technical. How do you collect more taxes? How do you enhance supervision of finances? How do restructure markets? All these are questions where technocrats can be very helpful. While Greece could in theory had access to these resources under a default option, the assistance is now much greater and the Greek government has a much greater incentive to listen and learn.

The second broad point is that Greek politics could risk losing their anchor if the country defaulted. For more than a generation, Greece has made a great deal of the fact that it belongs to Europe and is part of the European Club. It is not clear what default would do to that - for example, if Greece would have to (or be forced to) exit the euro. Regardless, Greece would be a pariah. Its ability to influence policy and be taken seriously would be compromised for years if not decades.

What is worse, that would translate into domestic political disorientation. What is the vision for Greece if not in Europe? It is to get back in Europe? To restore faith in “Greece” per se? These are deep questions that I fear few politicians would be ready to tackle, and it is not hard to see the country drifting from weak government to weak government. That could well be the ultimate consequence of a default.

1 comment:

  1. "if Greece stopped paying down debt, spending could be redirected to other uses. According to the IMF, the Greek state is going to spend €13 bn on interest payments in 2010 or 5.6% of GDP. For 2011, the projection is €15.2 bn or 6.5% of GDP. What if the Greek government did not have to pay this money?"

    is not that easy. I 'can't pay' doesn't work when you can and they sue you. Germany is still facing lawsuits over 1930's Hitler bonds and the interest is running ["Germany must face a lawsuit over bonds that defaulted under Adolf Hitler in the 1930s, a U.S. appeals court ruled..."]. Greece's biggest problem is that even a 50% haircut, absolutely nothing to sneeze at, leaves them with 70% debt to gdp ratio.
    Other issues :
    Money is owed to EU countries and EU banks, not to some faceless pensions funds. The impact will be felt right away and they will not be happy with Greece.

    Defaulting without reforms is just kicking the can down the road.

    But I think Greece should reach a deal over the debt and bite the drachma bullet. The Greeks will live in relative prosperity in no time as EURO buys a lot of vacations, olive oil and feta cheese. Now Croatia and Turkey are giving Greece a run for their money and that hurts.

    With new EU penalties of 0.2% of GDP for budget probs, Greece will be penalized drastically each year. Plus, they will 'never' enjoy the 2-3% rates they had until recently and that matters, see Japan with 200% debt but at 1-2% rate and locally owned. In short Germany screwed Greece and other PIIGS, no more bailout without bondholder pain, which means much higher rates, if they even buy any news bonds at all. And that means very little benefit for Greece to stay in the Euro, unless am EURO fit for Germany is one.


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