Did Europe's leaders imagine that they had put the Greek patient into the recovery ward in 2011? They certainly performed a lot of surgery. In October they granted the country a hefty debt forgiveness package, imposing a 50 per cent haircut on Greek bondholders. They agreed to increase the size of the official bailout for Athens to around €170bn (£140.73bn). They also successfully averted the threat of a national referendum on the austerity measures and saw a reasonable technocrat, Lucas Papademos, installed in the prime minister's office. "Job done" did they think to themselves?
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If so, the New Year has hit them like a bucket of cold water. A spokesman for the Athens government, Pantelis Kapsis, gave Europe's leaders the worst possible start to 2012 when he raised the prospect of Greece crashing out of the eurozone if the new rescue deal is not signed off promptly.
"The bailout agreement needs to be signed, otherwise we will be out of the markets, out of the euro," threatened Mr Kapsis.
Worse, the threat coincided with reports that International Monetary Fund (IMF) officials have privately warned the October debt forgiveness deal is not going to be enough to put Greece on a sustainable financial path.
One can sympathise with European policymakers who look like they are going to have to grapple, once more, with the nightmare of Athens' public finances. But they only have themselves to blame. The October deal was always dubious. The bondholder haircut is supposed to reduce the level of Greek debt to 120 per cent of GDP by 2020. But that figure made no sense.
Here's why: Assume Greece must pay interest rates of 5 per cent to service its 120 per cent of GDP debt pile from the end of the decade. With annual real growth of 3 per cent the Athens government would need to run a primary surplus (excluding interest payments) of 3 per cent indefinitely simply to keep its debt pile from growing. That would be a challenge for even the most fiscally disciplined of nations. And Greece does not have a history of fiscal discipline.
Remember too that this calculation is based on healthy, 3 per cent growth. If growth falls short of that, forget about it. The graph above shows what happens to the Greece's public debt trajectory if the country experiences lower growth. It is not a pretty picture.
History is not on Greece's side. The two US economists, Carmen Reinhart and Kenneth Rogoff, carried out a rigorous analysis of the relationship between sovereign debt levels and national growth rates through history. They found that nations with debt burdens above 90 per cent of GDP tend to have chronically lower growth rates.
Europe's leaders themselves seem to agree with this analysis, at least in principle. They agreed a new "fiscal compact" in Brussels last month that committed member states to aim for a target of a debt to GDP ratio of not more than 60 per cent. Presumably they agreed on this figure because they considered 60 per cent the prudent upper limit for national indebtedness. So why can Greece get away with 120 per cent?
The IMF is surely right to worry. For Greece's public finances to be put on a sustainable footing, Europe's leaders probably need to bring the country's sovereign debt pile well below 100 per cent.
In that case, why did Europe's leaders assert in October – in the face of all the available evidence – that a 120 per cent debt to GDP ratio would be sustainable for Greece?
The answer was politics. To reduce Greece's debt still further would be to force even bigger losses on German and French banks that hold a large chunk of Greece's €350bn of sovereign debt.
They had the devil's own job persuading the mighty banking lobby to accept a 50 per cent "voluntary" writedown in their Greek bond holdings in October. And, ominously, that deal has not yet been concluded, with some bondholders still resisting being burned.
There was a further problem. To have reduced Greece's debt burden below 120 per cent would have thrown the spotlight on Italy, which has a sovereign debt pile of a similar order of magnitude. If 120 per cent is unsustainable for Greece, why is it sustainable for Italy?
Could Greece surprise everyone by making it work? Anything is possible. But bear in mind that Greece has consistently shown European policymakers to be over optimistic over the past two years. At the time of the first bailout of Greece in 2010, European Union and IMF economists argued that Greek budget cuts and internal devaluation would result in a flood of private sector investment and a return to growth by this year.
In July 2010 the IMF forecast a 1.1 per cent expansion of the Greek economy in 2012 as a result of the country taking all the painful economic reform medicine. It has now dawned that this is simply not going to happen.
The IMF now forecasts a contraction of 2.9 per cent this year, to be followed by an expansion of just 0.5 per cent in 2013. Greece is likely to continue to struggle to hit its deficit reduction targets.
So what is the way out? Greece's official backers – European states and the IMF – are faced with a choice if they want to put the country's finances on a sustainable footing and avert the threat of Greece defaulting on its debts. They must either pump in more money in order to pay off the country's creditors, or force those creditors to writedown their loans further.
One way or another, that debt level needs to come down.Reuse content