Economic analysis by Filipe R. Costa
For the second time in just a couple of years, Greece is at the top of EU affairs threatening creditors with a potential default on its debt obligations. Against the wishes of the EU mandarins, Alexis Tsipras and his left-wing party Syriza were elected by the Greek people to replace the New Democracy party headed by Antonis Samaras.
From the very beginning, Tsipras has made bold promises to the population, focusing his campaign on the need to renegotiate the country’s debt obligations in order to re-launch economic growth. He believes Greece will never be able to pay in full its debt and that the current debt burden does not allow for GDP growth and employment creation. Fearing the consequences from debt repudiation, investors, EU officials and the IMF soon started threatening Greece, pointing to the disruption a Syriza win would create. Financial markets adjusted for the worst outcome – Greece defaulting on its obligations and exiting the Eurozone.
An organised chaos
Protecting and perpetuating the current state of affairs and interests is at the root of human nature. The EU, the IMF, investors, banks, the bailed out countries: none were interested in the changes that could come from a Syriza-led Greece, and they greatly amplified the negative consequences that could follow a Syriza win. Commentators predicted major disruption in financial markets, a Greece exit from the euro, hyperinflation, irreversible damage to the euro, and much more. The tone Tsipras adopted from the very beginning against the troika, along with his promises to reverse austerity measures, further contributed to the panic.
Two weeks after Syriza’s victory, Greece is still part of the Eurozone, the euro is doing well (even better, perhaps, than many would like it to do), European equities are in very good shape and the Athens Stock Exchange was not really decimated as many predicted.
There’s still a long way to go in terms of negotiation between Greece and its creditors, and there are still many things that can go wrong if both sides play hard ball instead of acting responsibly. However, I believe this will make a positive change to the future of the monetary union as a whole. Syriza at least had the courage to say no to something we already know is not going to succeed. Greece is already bankrupted and needs more than just transferring the debts from one entity to another. We shouldn’t forget that all that happened in 2010 was a massive transfer of the problem from private creditors to public creditors when Greece was bailed out. The problem was never solved and an even more severe moral hazard problem was created. Banks across Europe will eventually take on more risk in the future because they believe they will be bailed out if needed.
The EU needs to rethink its strategy
I believe we are at one of the most important junctions in the short history of the Eurozone. What has been interpreted as a major source of risk may in fact contribute to boosting growth and cohesion inside the Eurozone. This is the best time for European officials to realise what is staring them in the face: austerity measures didn’t work. Debt-to-GDP ratios for indebted countries are now larger than they were before 2008, most bailed out countries show a negative cumulative GDP growth between the end of 2008 and the end of 2014 (-25.6% for Greece, -6.6% for Portugal, -6.2% for Spain), and unemployment rates are at double-digits (Greece 25.8%, Spain 23,7%). Under such a devastating scenario, it is no surprise that people are hoping for a change in economic policy, as this is ample evidence that the current plan needs a replacement.
Why the austerity in the first place?
If you spend more than you earn for a prolonged time, relying too much on borrowed money, you will face larger expenses at a later date when you have to service the debt. At that point you will need to cut down on expenses; otherwise you would continue accumulating debt until a point where you would be unable to repay it. But if for some reason your income decreases more than your expenses, you will continue accumulating debt anyway. So, you need to look not only at expenses but also at income, as both are part of the debt equation. At a country level, the intuition is that you should cut unnecessary expenses but allow for income-generating spending that may help repay debt.
In 2010, two American academics, Carmen Reinhart and Kenneth Rogoff, published a study in the American Economic Review in which they demonstrated a negative correlation between external debt and GDP growth. They argue that when “gross external debt reaches 60% of GDP”, a country’s annual growth declined by 2%, and “for levels of external debt in excess of 90%” GDP growth was “roughly cut in half.” With this evidence, they paved the way for pro-austerity policies implemented in Europe. But those policies promoted by the IMF and core EU countries have not succeeded, as everyone was tightening at the same time and during a major recession. Not that I am supporting Keynesian policies, but doing the exact opposite could only end in disaster. European officials have several times praised the bailed out countries for their efforts but we know that, apart from the good intentions, the final effect was not positive. Why do you think the yield on a Portuguese 10-year sovereign bond has decreased from above 8% in 2011 to the current 2.5%? Debt-to-GDP in fact increased in the country, so the risk is still there. But, investors don’t see it because of central bank intervention. So, the difference here is not austerity but monetary policy.
Austerity further contributed to eroding economic and social conditions across Europe because it occurred during a recession. Additionally, the original study from Reinhart and Rogoff was later criticised by academics who pointed out serious flaws in the data, which in the end did not support the conclusions. In other words, there was no relation between high external debt and lack of GDP growth, undermining the basis for the current policy implemented by the troika in Europe.
With austerity based in a flawed model and six years of evidence showing deterioration in the social and economic conditions in the EU, it is time to look for alternatives. In a certain way, Syriza is igniting such a change, as they’re the only party until this point that was able to press in that direction. Not that I agree with the party’s view on economic policy, but they’re right in acknowledging that Greece is dead and broke, unable to repay its debts under the current troika agreement.
“We have resembled drug addicts craving the next dose. What this government is all about is ending the addiction,” said the incumbent Finance Minister Yanis Varoufakis, noting it was time to go “cold turkey”.
With 315 billion euros in foreign debt to repay, Greece would only be able to reduce its debt level if the country is able to show a dozen years of budget surpluses in a row. That’s something never achieved by a non-oil producing country and thus unlikely in Greece. At the same time, such is the level of interest payments each period, the government would have to cut its expenses so deeply that GDP would most likely decline by another 25% on top of the 25% decrease it already shows for the last six years. No government would survive it!
Greece is bankrupted and will never be able to repay its debt under the current arrangement. Creditors must realise their losses and negotiate with Greece in a sensible way, to recover the part of their money that is still recoverable. Giving additional loans won’t work because that is exactly what the troika has done to avoid a banking crisis – but without much success for the debt crisis. All they achieved was a redistribution of wealth as the hole is still there, and is now bigger. So, it is time to stop pretending there is no loss and to find an arrangement that can fit all parties.
Varoufakis has proposed a menu of debt swaps, which include a perpetual bond and growth-linked notes. Most of the credit owned by the IMF and the EU would be replaced by a new hybrid security with an equity-linked coupon payment. The main idea is that creditors would receive a coupon payment, which increases with GDP growth. Such instrument has the great advantage of aligning the interests of both the creditors and the borrower, as both would see growth-oriented policies as advantageous. A debt-for-equity swap is the logical way to go, in pretty much the same way as when a private company goes bankrupt. Creditors are turned into equity holders, as the entity is no longer able to repay its debts in full. In the case of a country, equity can very well be represented by a GDP-linked note. Creditors can still have a word on the future measures to be adopted, but this time they will be much more inclined towards adopting growth oriented policies as they also benefit from them.
Of course many will point to several problems arising from these growth-linked products. But, firstly, let’s not forget that swapping debt for equity here is just the consequence of a bankruptcy; and secondly, the flaws pointed out have been greatly exaggerated.
Many say that there may exist some moral hazard problems, as the government may understate the exact value of its GDP. In my view, if the debt was linked to inflation the problem would be much more severe as inflation is not desirable. But growth is desirable for a government and eventually the main outcome against which voters evaluate the performance of their politicians. If the government understates growth, then it is also reducing its chances of being re-elected. If the argument is not enticing, then it is possible to choose a measure for GDP growth detached from government surveillance to overcome any potential conflicts.
Others have also pointed to GDP revisions as another source of problems. Again, I don’t see why interest payment could not be adjusted to reflect GDP revisions. At the same time, GDP revisions have been shown to be residual across time.
While there’s much more one can say about GDP-linked debt, I believe the main message here is that something must be done and the troika must stop pretending Greece is not bankrupt. Many argue that Greece wants to tread the easy route of not paying its debts to avoid harsh adjustments and they additionally point to the moral hazard problem that could arise from any debt renegotiations. But let’s be pragmatic here. Has not Greece had enough so far? Didn’t Samaras cut expenses as much as he could? The truth is that it wasn’t enough and it would never be enough. GDP growth is needed by Greece as customers are by companies. As for the moral hazard issue, I would say there’s no greater moral hazard than to bailout banks and replace private debt with public debt. I don’t really see a moral hazard issue when you turn the ownership of a company over to its creditors. The equity-linked notes are the best option on the table right now. As the Nobel Prize Winner Robert Shiller puts it, the GDP-linked debt is “a much more rational distribution of risk”, which would recognise the bankrupt state of Greece and allow the country to grow again. The monetary union needs a compromise among all interested parties. Otherwise, it won’t last for many more years.