Wednesday, October 26, 2011

Four Principles on How Europe Should Deal with Greece

As leaders gather for yet another summit on the Eurozone crisis, the Greek crisis is at a critical inflection point. With bailout #1 having failed in its original premise (Greece going to the markets in 2012), and with bailout #2 seemingly derailed before it even got started, the European Union is looking for fresh ideas on what to do about Greece. Here are four principles on how to think about Greece.

No loan disbursement is guaranteed. Europe and the IMF have been good at ensuring that no loan disbursement under the first bailout is a “given.” While this creates continuous anxiety in Greek circles and in the Greek press, such pressure is necessary. It is only under the pressure of “we will not get the next tranche” that Greek politicians decide to act. In that sense, there can be no “solution” to the Greek problem – the constant fear that Greece may not get the next tranche is a necessary ingredient for success. That said, the troika has already disbursed 66% of its funds and has approved the next installment that brings the total to 70%. So its leverage from bailout #1 weakens with time.

Restructuring, voluntary or not, is always an option. A corollary to “tranche ambiguity” is “default ambiguity.” As a matter of strategy and tactics, Europe should stop saying that it will not allow Greece to default. The fear of default is necessary to force reform in Greece; it is also essential to secure a deal with foreign banks, which need to know that a less pleasant alternative awaits them if they do not volunteer some roll-over. More importantly, saying that default is an option is necessary because, well, Greece may well default. The debt math has never been good, and default is quite possible. Drawing a hard line against default just means you risk looking foolish afterward.

Leaving the Eurozone is off the table. For many economists, Greece’s decision to try to stay in the Eurozone is silly – why not exit the common currency, launch a new drachma and use a competitive exchange rate to generate export-led growth? While plausible, this syllogism is faulty for three reasons.

The first is that, from Europe’s perspective, the Greek problem is only incidentally a currency problem. European banks are exposed to Greek debt and they will be in trouble if they write it down – that problem is “currency-independent.” Their predicament would be the same if the debt were denominated in drachmas or any other currency.

Second, a new drachma does little to resolve the myriad structural problems that the country faces – a bloated public sector, tax evasion, lack of accountability, corruption, red tape that stifles entrepreneurship, broken educational and health systems, a slow and erratic judiciary, and many others. A drachma is a like giving aspirin to a patient that needs surgery.

Third, Greece leaving the Eurozone would be catastrophic for the Eurozone. Not because the Eurozone cannot live without Greece – it can – but because it will trigger capital flight from other EU countries. If you are a Spaniard or an Italian and you see that Greece has been kicked out of the Eurozone and that Greek savings have been converted from euros to drachmas (at a sharp discount), your first act will be to take your savings and move them out of the country. Such fear would trigger a greater deposit withdrawal than these countries have experienced so far. Their banking systems would collapse.

Push for real reform, not just fiscal gymnastics. This is the toughest one for Europe to manage. Greece needs to plug a big fiscal hole and, so inevitably, the international focus is on measures that will close that hole. Yet the process so far has suffered from several deficiencies.

The first is that Greece has continued to fudge the numbers, albeit in a less dishonest way – for example by accruing arrears and cutting from public investment to meet its fiscal targets (see here). A narrow focus on fiscal targets means more opportunity to do so by procrastinating on real reforms.

The second is that continuous tax hikes are yielding few results because the population at large has less money to give. Thus the measures are intensifying an already deep recession (see here). Again the single-minded search for revenue is counter-productive.

Third, new measures are creating widespread public fatigue and discontent, especially from people who see other reforms pushed back. So additional measures are harder to stomach. Such policies are also fueling a sense that the government is only going after the “little guys” while leaving entrenched interests intact.

And fourth, a focus on fiscal math has meant evading tackling with real problems – throughout 2010 and early 2011, the Greek government was focused on easy measures to close its fiscal gap. Of course any government starts with the easiest tasks first, but when it came to harder reforms, the government was neither prepared not had it build sufficient political will. The troika failed to see this until much later and is now belatedly expanding its mandate.


The four principles show decisiveness but they do not necessarily “resolve” the crisis. The crisis has no solution after all – what Europe can do is to draw some clear lines by saying that default is possible but exit from the Eurozone is not; and it then needs to assume a greater role to ensure that the broader agenda for change, rather than accounting fixes, drive the benchmarks for more financial support.


  1. It’s a good initiative, I went to your blog and I appreciate how you give back to the community. I agree with you, there are so much thinks to be done. In fact our continent is so poor and undeveloped that there are lots of opportunities; any little entrepreneurial activity can lead to great success if it’s well conducted.

  2. Very good analysis, as on other occasions!

  3. Excellent post Nikos, thanks for making it all seem so clear. I only hope senior people in Berlin, Paris and Brussels are reading this...

  4. Upon announcement of the new agreement, Papandreou mentioned that this would allow Greece to have more time to implement reforms. While nearly everyone agrees that there has been footdragging in ministries and government bodies, what dismays me is the question of whether there is even the technical capacity and knowledge to adopt reforms.

    Are Greeks so used to doing things with so much red tape and corruption that they cannot figure out how to change things? Are Greeks like the proverbial frog in the pot coming gently to a boil?

    Reform is possible. The experience of lesser developed countries demonstrates this to be true. Consider the countries of Georgia and FYR Macedonia: In the Doing Business 2012 Index they rank 16 and number 22 respectively. Greece is at number 100--largely due to its dismal perfromance in registering property and starting a business.

    Nikos is absolutely right in that the Troika should not relax its oversights of needed structural reforms in the country. See

  5. No discussion on the political and economic reform on Greece is ever complete without taking into account what Greece spends on military armament.

    If you consider that Greece has been spending 5% of GDP since at least since the 1970s all on credit (I would say Greece has been spending somewhere close to this figure since the older George Papandreou days in the 1950s)
    then this portion of the expenditure is responsible for at least 100billion of the current debtload not even including interest and rollover fees.

    If Greece's military expenditure is deemed a necessity for the good of its citizens then it must be accurately budgeted for similar to interest expenses as such a large expenditure of total income cannot be ignored.

    This portion of Greek expenditure is an inconvenient truth for other arms producing nations trying to work out a bailout...not accounting for it is like not accounting for rental expenses for a individual.

    I totally agree with the blog master that Greece needs a fundamental reform on all levels of public administration..

  6. The tax hikes in one form or another will probably fail to pay any significant portion of outstanding debt.

    Unless the extra revenues is put into some form of escrow account and is used for the sole purpose of paying down existing debt via buying its own bonds and shorter term paper.

    Actually since most of the euro based notes and bonds were issued at interest rates very close to German levels during the last 10 years....if Greece was a hedge fund and kept the money and invested it in German 10 year variety they will be booking billions of Euro in profits. We just have to make sure that the finance ministers do not come back on sue the government for millions of euros in unpaid they would have earned had then worked in a bank or hedge fund.

    As it stands now even the extra levy on properties will probably go into the general account and it will be jumbled up and spent on meeting interest, pensions, arms and who knows what.

    Either way some sort of debt moratorium seems to be the only viable option to me.

    In this way the Germans and other supporters of the Troika bailout package can only vent their anger at their own private banks as the tax money will be used to bail out their own highly leveraged financial institutions.

    If a bank needs a bailout from the state because a portion of their loan portfolio becomes classified as "non-performing" don't you think that is a serious problem?

    As it became clear during the 2008-9 sub prime fiasco some of these institutions were silly enough to short CDS insurance on their risky loan portfolio when a prudent banker should have been buying it to hedge their portfolio.


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