Financing vs. Restructuring Greece

“…crises and emergencies may be welfare-improving and hence desirable. When ongoing social conflict implies that an economy has settled in a Pareto-inferior equilibrium, radical changes are often needed to break the stalemate and put the economy on a welfare-superior path. The necessary introduction of drastic measures, which may involve sharp tax increases and expenditure cuts, is usually unpopular and forcibly resisted because of distributional concerns. The distress associated with living through an economic crisis often makes these measures acceptable…”

I wonder if these words, taken from a paper published by Allan Drazen and Vittorio Grilli[1] in 1993, came back Grilli’s mind, who now serves as Director General of the Italian Treasury, during the gruelling negotiations that led to the European Council to approve the mega “Save the Euro” package on May 10. Yet the euphoria following the announcement was short-lived: two days after the news, the stock markets plunged, spreads on sovereign bonds were up again and the euro continued to slide. So, is the rescue package a waste of money, as many critics argue? Is a (orderly, of course) default now preferable to a disorderly default later?  Let us consider the most common objections to the European-IMF rescue plan.

 1. The crisis in Greece (and Portugal) is not a liquidity crisis, but a solvency crisis, so that money should not be wasted. In fact, the distinction between liquidity crisis (temporary lack of funds) and solvency (the debtor cannot repay, neither now or ever) is very questionable. Creditors are not willing to roll over maturing loans, and precipitate a liquidity crisis, precisely because they consider the debtor insolvent. Otherwise, they would gain by extending credit, possibly allowing the country to repay the debt. In a nice paper[2] published in 1988, Paul Krugman makes the point that even when it is very likely (but not certain) that the debtor country is insolvent, existing creditors may (collectively) benefit from extending their loans even if the new lending is unprofitable! Financing gives the existing creditors, say French and German banks, an option value: if the country turns out to do relatively well, creditors will not have written down their claims unnecessarily. However, will Greece eventually afford to repay its debt?

2. Better to face reality: the adjustment required from Greece is not economically / politically sustainable and hence a default with debt restructuring is preferable to new financing. Figure 1 shows the evolution of the Greek government debt (mostly held abroad) in different scenarios. In the first one (blue line) there is no fiscal adjustment. Debt explodes (exceeds 200% of GDP in 2014). In the second scenario (red line), the government implements a “tears and blood” package in five years by reducing the primary balance of 11 points of GDP (“the IMF plan”). As shown in the graph, this is not enough to curb the debt. In the third scenario, I add a EU-IMF subsidized loan that reduces the real interest rate, net of inflation, from 8, 5 to 3.5%. In this case, after peaking at 154% of GDP in 2016, debt eventually starts falling.

 

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Is such scenario feasible? The following Table 1 (taken from a paper by Alcidi and Gros) shows several episodes of stabilization in recent European history. Cuts of similar magnitude and distributed in comparable periods have occurred in Denmark, Sweden, Greece, and Italy. However, the current adjustment in Greece is more difficult for at least two reasons: a very serious European recession, and no room for competitive devaluation to boost growth.

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3. Since costs of default are low (see Borensztein and Panizza, here), it is not a big deal if Greece goes bankrupt. The point, of course, is not the size of default costs for Greece, but the potentially catastrophic consequences of a contagion to Spain and Italy (plus Portugal and Ireland). Even if this is a low probability event, given the strong economic and financial integration of European banking sectors, the expected cost may be very large. The signs of contagion are here: after Greece, in recent days also the default probabilities implicit on Portuguese CDS spreads now show an “inverted slope” (see Figures 1 and 2): the market considers more likely a Portuguese default within a year rather than at more distant maturities.

 

Figure 2: Conditional probabilities of default from CDS spreads at different maturities, Greece

 

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Source: DataStream (research assistant G. Trigilia)

Figure 3: Conditional probabilities of default from CDS spreads at different maturities, Portugal

 

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Source: DataStream (research assistant G. Trigilia)

4. All is needed is a coordinated plan for fiscal consolidation in Europe. Achtung! While it is obviously appropriate for countries at risk to implement policies of fiscal consolidation, a coordinated EU – tightening would have very large deflationary effects, worsening the vulnerability of high debt countries and possibly killing the fragile European recovery.

Ultimately, the European plane-IMF seems a reasonable response to an emergency. Whether it will succeed largely depends on the next steps that the large European countries, Germany in particular, will decide to take.

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[1] Allan Drazen and Vittorio Grilli, “The Benefit of Crises for Economic Reforms”, The American Economic Review, Vol 83, No. 3 (Jun. 1993), pp. 598-607  

 
[2] P. Krugman, 1988, “Financing vs. Forgiving Debt Overhang, “Journal of Development Economics, 29: 253-26  


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