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?
Click HERE to view graphic
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.
Comments