by Ashoka Mody
Appeared originally at Voxeu.org 18 June 2015
The Greek crisis continues to take centre stage in policy debates. This column provides insight on the topic using evidence from three recent IMF studies. A suggested programme for Greece includes debt relief (debt equal to 50% of GDP and payable over 40 years), scaling down the banking system, and setting a flat 0.5% of GDP primary surplus over the next three years.
Some expected that the Greek government would have ‘blinked’ by now. Others believe that by not conceding, the Greeks have bungled the discussions with creditors. And yet others think that the Greeks may turn out to be the better negotiators after all. But the drama of the never-ending exchange is obscuring the principles.
A medical analogy, often used to describe international financial rescues, is useful to frame the issues. When a patient comes into an emergency trauma room, the doctor on the floor typically does not refuse to treat him because the patient has lived an unhealthy life. Nor does the doctor ask him to first run around the block a few times – as proof of good faith – before stemming his blood flow. And certainly no doctor will first increase the haemorrhaging as a warning before treating the patient.
The troika’s prescriptions
But by threatening to cut off Greek banks from funding and by keeping the Greek economy on a leash, the troika doctors have made the Greek patient worse with the passage of every day. The Greeks, it is argued, could have saved themselves this outcome by agreeing on the very first day to the troika’s conditions. In essence, the troika programme stayed with the strategy that has been followed over the past five years:
- Borrow more money (this time mainly from the European authorities) to repay one group of creditors (the IMF, to which substantial repayments are due);
- Stay focused on more austerity, steadily increasing the primary surplus (the budget surplus not including interest payments); and
- Undertake structural reforms—changes in labour and other markets to improve the Greek economy’s longer-term growth potential.
The Greeks could have agreed to this plan and, eventually, not delivered—just like they have not delivered for the past five years. In part, the Greeks have tried that even in this round. The Greek ‘agreement’ on the primary surpluses is a façade of numbers with little reality behind them. For five years, this has not worked.
Three IMF analyses of the Greek crisis
To see where things have gone wrong, it is helpful to follow three IMF studies:
- Over-indebted countries struggle to grow.
In its famous mea culpa for delaying the restructuring of Greek debt, the IMF acknowledged a well-respected academic tradition (IMF 2013). The ‘debt-overhang’, as economists term it, inhibits new investment and growth. For this reason, it is in the interests of creditors as well as debtors to forgive debt (for an early statement, see Krugman 1988). The evidence for this proposition is clear, including in an important paper by the University of Chicago economist and former Governor of the Fed, Randall Kroszner (Kroszner 1998). Reinhart and Trebesch similarly find that growth picks up after debt relief (Reinhart and Trebesch 2014).
Some might say that Greece does not have a debt overhang. With the ultra-low interest rates on its official debt, Greece, it is argued, can repay its debt without sacrificing growth and reasonable social objectives. But even under the troika’s calculations, the conclusion that Greece can comfortably pay back its debts is true only on the assumption that Greece will increase its primary surpluses. The troika’s demands earlier this year were for an extraordinary ramp up in primary surpluses—from a small negative number to over 4% of GDP. That demand has been steadily scaled down over the past few months. But even now, the troika requirement is that the surpluses increase by about 1 percentage point of GDP a year for the next three years. To achieve that goal would require a contraction of discretionary spending well above 1% of GDP a year. That, by any definition, is significant fiscal austerity, coming on top of an extraordinary austerity over the past five years.
That leads to the second set of IMF analyses.
- Austerity in a weak economy is self-defeating (Blanchard and Leigh 2013). As the budget deficit is reduced, the economy slows down, and the ability to repay debt is undermined. Indeed, austerity can be self-defeating (Eyraud and Weber 2013).
Here is how this principle applies today to Greece. Recall that prices in Greece have been falling for about two years now. Since debt repayment obligations do not change when businesses sell at lower prices or when wages fall, businesses and households struggle to repay their debt in a deflationary environment. Investment and consumption are held back, the government receives less revenue, making its debt repayment harder. If austerity is imposed in this deflationary setting, the weaker demand forces prices and wages down faster, making debt repayment even harder. This is the so-called debt-deflation cycle. Greece is in a debt-deflation cycle.
For this reason, increasing the VAT tax burden, for example, is a terrible idea. Japan—which, despite its troubles, is an infinitely stronger economy than Greece—only recently got its wind knocked out by a premature increase in VAT rates. To be sure, the VAT rates will eventually need to be raised, and pensions and wages will need to be scaled back. But setting a demanding timeline now—before growth is firmly established—will keep Greece trapped in a debt-deflation cycle. The debt-to-GDP ratio, which was about 130% of GDP when the Greek crisis began in 2009 has risen to about 180%, and will keep rising.
Thus, the third element of the troika strategy, namely that Greece should do structural reforms and spur growth even while it does ‘growth-friendly’ austerity. These are soothing terms. So, consider the third piece of IMF evidence.
- Structural reforms have, at best, an uncertain payoff (IMF 2015). In Box 3.5 of this recent chapter from the IMF’s World Economic Outlook, the updated finding has a long pedigree. Policy measures can possibly create an environment for growth in the long-run, but no immediate payoffs should be expected.
Indeed, where structural reforms are a code phrase for reducing wages and weakening employment contracts—as they are in the Greek context—we circle back to the immediate problem of curtailing demand in an already deflationary environment. But even the long-term growth benefits of these measures are unclear. With lower wages comes lower productivity. Both economic theory and evidence support this concern. And Germany’s much vaunted success came not from suppressing wages but from corporate-labour agreements to outsource labour-intensive tasks to lower-wage economies while German manufacturers upgraded their technology (Dustmann et al. 2014). The IMF’s analysis finds that investing in R&D to raise productivity in the information technology industries may have a long-term pay off. But that will be reaped over decades not in time to extricate Greece from its debt-deflation cycle.
Finally, those calling for throwing Greece out of the Eurozone (Financial Times, June 2015) must confront Barry Eichengreen’s essay on the costs of breaking up the Eurozone (Eichengreen 2010). Eichengreen warns that a Greek exit could have consequences for the European and global economy that would dwarf the panic following the bankruptcy of Lehman Brothers.
A suggested programme for Greece
So what should a Greek programme look like? The objective should be to return Greece to the financial markets in a phased manner. Following the medical analogy, the objective should be to get Greece out of the emergency room, work through rehab, and then resume as normal an existence as it can. To that end, the key elements of a Greek programme must be:
- Forgive Greek debt so that it comes down to 50% of GDP payable over 40 years (this is akin to stemming the blood loss).
- Scale down the banking system, which has been badly damaged and will continue to create vulnerabilities (this is the surgery).
- And agree to a flat 0.5% of GDP primary surplus over the next three years, which even Greece can deliver (light yoga in rehab).
With this preparation and its low debt obligations, Greece will be able to tap markets. To those concerned that Greece will return to its bad ways, the new debt should be in the form of sovereign cocos (Mody 2013), which will contractually provide for standstills on repayments if debt exceeds 75% of GDP. The standstill provision will limit Greek access to markets and raise the costs of borrowing. Greece will learn to live within its means. This would be like Greece training for a 5K race.
If that goes well, then the Greeks can decide if they want to run a marathon, in which case they will need to change their social contract. How they do that—through reduced pensions, lower wages, increased VAT, or through more effort to rein in Greek oligarchs—is a matter for the Greeks to decide. An international consortium, backed by hysterical media, cannot micromanage Greece. The Greeks may well choose to let their standard of living gradually decline. That will be their choice.
Staying on the present course will mean that Greece will shuttle between the emergency room and rehab. In particular, the idea of staggered relief is set to guarantee such an outcome. The debt forgiveness will come in driblets. It will be accompanied by indefinite pain for Greece and its creditors.
Blanchard O and D Leigh (2013), “Growth Forecast Errors and Fiscal Multipliers”, IMF working paper 13/1.
Dustmann, C, et al. (2014), “From Sick Man of Europe to Economic Superstar: Germany’s Resurgent Economy,” Journal of Economic Perspectives 28(1): 167-188.
Eichengreen, B (2010), “The Breakup of the Euro Area”, in Europe and the Euro, Alesina A and F Giavazzi (eds), NBER, University of Chicago Press.
Eyraud L and A Weber (2013), “The Challenge of Debt Reduction during Fiscal Consolidation”, IMF working papers 13/67.
IMF (2013), “Greece: Ex Post Evaluation of Exceptional Access under the 2010 Stand-By Arrangement”, IMF Country Report No.13/156, June.
IMF (2015), “Where are we headed? Perspectives on potential output”, Chapter 3 of World Economic Outlook: Uneven Growth—Short- and Long-Term Factors, April.
Koszner, R S (1998), “Is it better to forgive than to receive? Repudiation of the gold indexation clause in long-term debt during the Great Depression”, preliminary draft, October.
Krugman, P (1988), “Financing vs. Forgiving a Debt Overhang”, Journal of Development Economics 29:253-268.
Mody A (2013), “Sovereign debt and its restructuring framework in the euro area”, bruegel.com, 12 August.
Reinhart C M and C Trebesch (2014), “Sovereign debt-relief and its aftermath: The 1930s, the 1990s, the future?”, VoxEU.org, 21 October.