What Should Greece Do?

by Elliott Morss

Editor’s Note: We all know the story: Greece has been living beyond its means for more than a decade. As a consequence, it is running out of money. And as Econintersect’s Dr. Elliott R. Morss has documented in an earlier piece, Greece has entered into an unemployment-generating program in return for IMF/EU financial support. The program is not popular in Greece: the government barely got the IMF/EU austerity package though the Greek parliament. There have been riots, and there will be more riots.

One might ask whether this austerity program is the best policy for Greece?  Dr. Morss examines this question below in the form of a letter to President Papoulias.

President Papoulias:

Things are not going well in your country. GDP fell 2.0% in 2009, 4.5% in 2010, and the IMF estimates it will fall another 3.0% in 2011. The unemployment rate is just below 15% and will go higher as the teeth of the EU/IMF imposed austerity plan take hold. Greece has been living beyond its means for some time. It is now in a desperate situation, and there are no easy solutions.

In 2009, the government deficit was 15.4%. It was reduced to 9.6% in 2010. And if Greece sticks to the austerity program targets, it should fall to 6.2% in 2012. The IMF estimates that 2009-2012 government deficit reduction will increase unemployment by 2.8 percentage points.

Why is the country in such trouble? There are three key problems:
•    the government deficit;
•    the country’s balance of payments deficit, and
•    the government debt. 
It is important to understand that without its own central bank, Greece has no option other than borrowing to cover its deficits. And with the government debt level now at 150% of its GDP, there are few lenders out there.

Table 1 provides details on the government deficit. The only way to finance the deficit is by either selling off government enterprises or by borrowing. There are not many investors left to buy Greek debt.

Consider now the balance of payments. Greece runs a current account deficit which means the country’s imports plus income receipts are greater than exports and income payments (including interest payments on debt). In Table 2 the Current Account deficits are shown along with projections of debt amortization coming due.

The projected debt amortization payments are extremely large. And it is doubtful that even with EU/IMF support they can be paid.

Table 3 provides the IMF’s projection on how the gap could be financed. It is wishful thinking. In the current setting, there is no way such large amounts can be rolled over, even with additional support from the IMF and the EU.

Mr. President, this debt is not sustainable. I recommend that Greece defaults on the debt. Defaulting is no panacea for Greece. There will be real problems. But without having to make the debt amortization payments, Greece will have the time to get its house in order.

Before making a public announcement, you should inform the EU/IMF of your decision. You should tell them that you will not default on their loans because you want to make most of the reforms that you have negotiated with them. You should keep in mind that what you are being asked to do by the French and Germans already constitutes a default – see below.

Greek Creditors – When Is a Default Not a Default?

When you borrow money from someone, you write up a loan agreement saying how much you are borrowing, what the cost will be (interest), and when you will pay it back. A default happens when the debtor does not abide by the loan agreement. The Greek creditors have looked at Greece’s situation and have concluded it cannot handle the debt payments required by current loan agreements. 

Consequently, the French and the Germans are trying to get all creditors to agree to new terms. In essence, they are trying to stretch out the debt so annual amortization payments will be lower. If they get this approved by most of the creditors, the old loan agreements will be torn up and new ones written. If Greece signs the new agreements, it will have defaulted on the earlier agreements. But the French and Germans prefer the term “rollover” to “default”.

Now, consider what I am recommending. Greece tells all its creditors it cannot afford its debt burdens and it is suspending all debt payments indefinitely. The creditors, mostly banks, don’t want this to happen because they would have to write down the value of these loans on their books. They far prefer the proposed rollover default.

But Mr. President, you have to understand the creditors have only one thing in mind: getting all their loans paid back. They know Greece cannot handle its current debt burdens, so they are trying to change them just enough so you can just afford to make the payments. 

You should not worry about the lenders. Why has anyone lent money to Greece in the last five years? It was clear the country was on an unsustainable downward path. The answer is Credit default swaps (CDS). Ever heard of them before? Like as a primary contributor to the US banking collapse? CDS allow banks to buy Greek debt and get “risk insurance”. Remember the AIG office in London that earned fees for insuring mortgage backed securities and their derivatives? It is the same thing going on with Greece:

•    Banks buy Greek debt;
•    They then buy “risk insurance” by paying a fee to another financial, institution for CDS;

And do you know what the European governments are worried about here? The banks that insured the debt that are now holding the CDS. What if insurance payments are required? Here we go again. And this brings me back to a point that I have made for several years: banks should manage their own loans and earn virtually no money from trading in CDS or other derivatives.

I am not the only person making this point. I quote from “Bank Regulation’s Capital Mistake” by Tufts’ Professor Amar Bhidé:

“Reversing the robotic gigantism of banking ought to be the top priority for reform. Bankers were once supposed to know every borrower, and to make case-by-case lending decisions. Now, however, banks use models conjured up by faraway financial wizards to mass-produce credit and a range of derivative products. Mass-production favors the growth of mega-banks, so, unlike the misjudgments of lending officers, these behemoths’ defective models have had disastrous consequences….

Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks. Regulators then shifted to edicts requiring banks to maintain a specified capital cushion, thick enough to cover potential losses. This approach presupposes that bank assets and exposures can be accurately measured. In fact, the financial statements of mega-banks are impenetrable works of fiction or wishful thinking….

We can no longer afford to rely on old-fashioned examination for mega-banks loaded with mass-produced risks. And because stockholders or raiders can’t force streamlining, governments must require these banks to shed activities that no one can manage or regulate and stick to hands-on case-by-case lending. With huge profits and bonuses at stake, mega-banks won’t readily abandon their model-based businesses; but, unless that happens, placing most of our bets on top-down rules would be reckless folly.”

And what has happened to the CDS insurance fee against default? According to an article appearing in Econintersect, it is approaching 25%!

The Consequences of Default

Mr. President, you have to be prepared for the negative fallout resulting from your default announcement. Things might get so nasty that you are asked to leave the Euro zone. It does not matter. You can still use the Euro as your currency.

But your responsibility is to the citizens of Greece, not to the French and German bankers who lent you money with no regard to the risks involved.

Elliott Morss, Ph.D.

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Elliott Morss has a broad background in international finance and economics. He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance.

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