Sunday 22 May 2022 | 07:10 | SYDNEY
Sunday 22 May 2022 | 07:10 | SYDNEY

Greece: It didn't have to be this way


Stephen Grenville

11 July 2011 09:36

We can't re-run history, but it looks like a serious error was made early last year in not allowing Greece to default.

The fundamental position was clear, even at the time: Greece was insolvent rather than illiquid. The time-honoured solution, for companies and countries, is that creditors lose their money. In this case, however, a serious problem in a small country (accounting for only 2.5% of Euro-area output) has been allowed to infect the global financial system and weigh down overall world growth.

Default would have simplified and focused the domestic political problem of balancing the Greek budget. Unable to borrow, the Government would have had no choice but to raise taxes. Instead of demonstrators opposing tax increases, you might have seen public servants in the streets demanding that taxes be paid so that they, in turn, could be paid.

Of course this would have been painful. But experience elsewhere suggests that the pain is temporary. It looks like default doesn't stop a country from borrowing for very long. Iceland, after its stunning collapse in 2008, is back in the market, paying a modest 5% for its recent US$1 billion debt issue.

The Greece bailout was justified as a way to stop contagion to other weak Euro countries – principally Portugal and Ireland. This type of argument is familiar to bank regulators world-wide.

When a bank gets into trouble, everyone argues that the bank is 'systemic' and has to be saved in order to prevent contagion. Knowing this bias, regulators build in offsets that remind them that it is often best to let a bank fail. Experience tells them that they either have to give a troubled bank enough support to guarantee its viability, or they have to shut it down definitively. In the latter case, they must convince markets that the troubled bank was unique, with its problems not applicable to others.

This same choice was present for Greece. Either it had to be unambiguously supported, or it had to be allowed to default quickly, with the full effort then being focused on demonstrating that Portugal and Ireland were quite different. Instead, Greece has been allowed to limp along, neither definitively saved nor put out of its misery.

Who is to blame? One intrinsic problem in every insolvency is that none of the parties involved has any incentive to declare failure. In this case, politicians in Greece and Europe, the Greek banks, the foreign bank creditors (mainly in Germany and France), and the European Central Bank (which holds €50 billion of Greek debt) all had a strong incentive to 'kick the can down the road'. Better to pretend that the assets on their balance sheets were still worth the full face value. Better to leave the problem for your successors to sort out.

The only party which might have prevented this prevarication was the IMF. But with Europeans dominating the Fund's Executive Board and a French politician as Managing Director, the decision process was compromised. The Fund not only made a substantial contribution to the €110 billion bail-out package, it acts as the chief strategist/enforcer to the Greek authorities.

Of course, the intrinsic problems go back much further and can't be blamed on the IMF. Greece (and the other peripheral countries) could issue Euro-denominated debt, yet financial markets ignored the reality that, although Greek debt might be in Euros, it was still Greek debt. The credit rating agencies, as usual, were hopelessly tardy in identifying the reality —Greece was downgraded from investment grade only six months ago.

What happens now is as inevitable as it is unsatisfactory.

The IMF, European taxpayers and the ECB have put in enough support to cover a bit over half of Greek official debt, but it seems all three parties have reached their limit.

It is now too late to have a clean default. The markets have spent the last year worrying out loud that a default would trigger contagion to the other peripheral countries, with this view endorsed by the head of the ECB. Making the case that Greece was idiosyncratic no longer seems feasible. The threat of contagion is now very real.

 Now that the private sector can't unload any more debt on the Euro taxpayers, the debt will be restructured so that it doesn't have to be repaid any time soon and the interest rate will be reduced. The can will be kicked a bit further down the road.

This resolves nothing. The face value of the debt will remain, as will Greece's patent inability to repay it. The deflationary pressure on the Greek economy puts budget balance out of reach. Economic activity can't be boosted by improved international competitiveness so long as Greece remains in the Euro area.

The whole painful process will thus fester, though sooner or later, something will trigger a solution. Perhaps the Greek people will decide that it is better to default and their politicians will heed this message. More benignly, given enough time, Europe might sort out a debt-reduction along the lines of the Brady plan which eventually sorted out Latin American debt, after nearly a decade.

Will the international community examine why the opportunity of default was missed in 2010? Perhaps, but these port-mortems are carried out by those who made the mistakes. Thus we will be destined to repeat them.

Photo by Flickr user PIAZZA del POPLO