It’s Not About Greece Any More

The Greek “rescue” package announced last weekend is dramatic, unprecedented, and far from enough to stabilize the eurozone. 

The Greek government and the European Union (EU) leadership, prodded by the International Monetary Fund (IMF), are finally becoming realistic about the dire economic situation in Greece.  They have abandoned previous rounds of optimistic forecasts and have now admitted to a profoundly worse situation.  This new program calls for a total of 11% of GDP in terms of “fiscal adjustments” (i.e., reduction in the budget deficit; now meaning government spending cuts mostly) in 2010, 4.3% in 2011, and 2% in 2012 and 2013.  The total debt to GDP ratio peaks at 149% in 2012-13 before starting a gentle glide path back down to sanity.

This new program is honest enough to show why it is unlikely to succeed.  Daniel Gros, an eminent economist on euro zone issues based in Brussels, has argued that for each 1% of GDP decline in Greek government spending, total demand in the country falls by 2.5% of GDP.  If the government reduces spending by 15% of GDP – the initial shock to demand could be well over 30% of GDP.  Obviously this simple rule does not work with such large numbers, but it illustrates that Greece is likely to experience a very sharp recession – and there is substantial uncertainty around how bad the economy will get.  The program announced last weekend assumes Greek GDP falls by 4% this year, then by another 2.6% in 2011, before recovering to positive growth in 2012 and beyond. 

Such figures seem extremely optimistic, particularly in face of the civil unrest now sweeping Greece and the deep hostility expressed towards Greece in some north European policy circles. 

The pattern of growth is critical because, under this program, Greece needs to soon grow out of its debt problem.  Greece’s debt/GDP ratio will be a debilitating 145% of GDP at end 2011.  If we put more realistic growth figures into the IMF forecast for Greece’s economy, e.g., with GDP declining 12% to end 2011, then the debt/GDP ratio may reach 155%.   At these levels, with a 5% real interest rate and no growth, the country needs a primary surplus at 8% of GDP to keep the debt/GDP ratio stable.  They will be nowhere near that level.  The IMF program has Greece running a primary budget deficit of around 1% of GDP in that year, and that assumes a path for Greek growth that can only be regarded as an “upside scenario”. 

The politics of these implied budget surpluses remain brutal.  Since most Greek debt is held abroad, roughly 80% of the budget savings the Greek government makes go straight to Germans, French and other foreign debt holders (mostly banks).  If growth turns out poorly, will the Greeks be prepared for ever tougher austerity to pay the Germans?  Even if everything goes well, Greek citizens seem unlikely to welcome this version of their “new normal”.

Last week the European leadership panicked – very late in the day – when they realized that the euro zone itself was at risk of a meltdown.  If the euro zone proves unwilling to protect a member like Greece from default, then bond investors will run from Portugal and Spain also – if you doubt this, study carefully the interlocking debt picture published recently in the New York Times.  Higher yields on government debt would have caused concerns about potential bank runs in these nations, and then spread to more nations in Europe. 

When there is such a “run” it is not clear where it stops.  In the hazy distance, Belgium, France, Austria and many others were potentially at risk.  Even the Germans cannot afford to bail out those nations.

Slapped in the face by this ugly scenario, the Europeans decided to throw everything they and the IMF had at bailing out Greece.   The program as announced has only a small chance of preventing eventual Greek bankruptcy, but it may still slow or avert a dangerous spiral downward – and enormous collateral damage – in the rest of Europe. 

The IMF floated in some fashion an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities.  This is not a surprise – leading European policymakers are completely unprepared for broader problems that would follow a Greek “restructuring”, because markets would immediately mark down the debt (i.e., increase the yields) for Portugal, Spain, Ireland, and even Italy.  The fear and panic in the face of this would be unparalleled in modern times: When the Greeks pay only 50% on the face value of their debt, what should expect from the Portuguese and Spanish?  It all becomes arbitrary, including which countries are dragged down.  Someone has to decide who should be defended and at what cost, and the European structures are completely unsuited to this kind of tough decision-making under pressure. 

In the extreme downside scenario, Germany is the only obvious safe haven within the eurozone, so its government bond yields would collapse while other governments face sharply rising yields.  The eurozone would likely not hold together.

There is still a narrow escape path, without immediate debt default and the chaos that would produce:

1.  Talk down the euro – moving towards parity with the US dollar would help lift growth across the eurozone.

2.  As the euro falls, bond yields will rise on the eurozone periphery.  This will create episodes of panic.  Enough short-term financing must be in place to support the rollover of government debt.

3.  Once the euro has fallen a great deal, announce the ECB will support the euro at those levels (i.e., prevent appreciation, with G20 tacit agreement), and also support the peripheral eurozone nations viewed as solvent by buying their bonds whenever markets are chaotic. 

4. At that stage, but not before, the eurozone leadership needs to push weaker governments to restructure – that will include Greece and perhaps also Portugal?  Hopefully, in this scenario Spain can muddle through.

5. European banks should be recapitalized as necessary and have most of their management replaced.  This is a massive failure of euro groupthink – including most notably at the political level – but there is no question that bank executives have not behaved responsibly in a long while and should be replaced en masse. 

To the extent possible, some of the ensuing losses should be shared with bank creditors.  But be careful what you wish for – the bankers are powerful for a reason; they have built vital yet fragile structures at the heart of our economies.  Dismantle with care.

The Greek “rescue” package announced last weekend is dramatic, unprecedented, and far from enough to stabilize the eurozone. 
The Greek government and the European Union (EU) leadership, prodded by the International Monetary Fund (IMF), are finally becoming realistic about the dire economic situation in Greece.  They have abandoned previous rounds of optimistic forecasts and have now admitted to a profoundly worse situation.  This new program calls for a total of 11% of GDP in terms of “fiscal adjustments” (i.e., reduction in the budget deficit; now meaning government spending cuts mostly) in 2010, 4.3% in 2011, and 2% in 2012 and 2013.  The total debt to GDP ratio peaks at 149% in 2012-13 before starting a gentle glide path back down to sanity.This new program is honest enough to show why it is unlikely to succeed.  Daniel Gros, an eminent economist on euro zone issues based in Brussels, has argued that for each 1% of GDP decline in Greek government spending, total demand in the country falls by 2.5% of GDP.  If the government reduces spending by 15% of GDP – the initial shock to demand could be well over 30% of GDP.  Obviously this simple rule does not work with such large numbers, but it illustrates that Greece is likely to experience a very sharp recession – and there is substantial uncertainty around how bad the economy will get.  The program announced last weekend assumes Greek GDP falls by 4% this year, then by another 2.6% in 2011, before recovering to positive growth in 2012 and beyond. 
Such figures seem extremely optimistic, particularly in face of the civil unrest now sweeping Greece and the deep hostility expressed towards Greece in some north European policy circles. The pattern of growth is critical because, under this program, Greece needs to soon grow out of its debt problem.  Greece’s debt/GDP ratio will be a debilitating 145% of GDP at end 2011.  If we put more realistic growth figures into the IMF forecast for Greece’s economy, e.g., with GDP declining 12% to end 2011, then the debt/GDP ratio may reach 155%.   At these levels, with a 5% real interest rate and no growth, the country needs a primary surplus at 8% of GDP to keep the debt/GDP ratio stable.  They will be nowhere near that level.  The IMF program has Greece running a primary budget deficit of around 1% of GDP in that year, and that assumes a path for Greek growth that can only be regarded as an “upside scenario”. The politics of these implied budget surpluses remain brutal.  Since most Greek debt is held abroad, roughly 80% of the budget savings the Greek government makes go straight to Germans, French and other foreign debt holders (mostly banks).  If growth turns out poorly, will the Greeks be prepared for ever tougher austerity to pay the Germans?  Even if everything goes well, Greek citizens seem unlikely to welcome this version of their “new normal”.
Last week the European leadership panicked – very late in the day – when they realized that the euro zone itself was at risk of a meltdown.  If the euro zone proves unwilling to protect a member like Greece from default, then bond investors will run from Portugal and Spain also – if you doubt this, study carefully the interlocking debt picture published recently in the New York Times.  Higher yields on government debt would have caused concerns about potential bank runs in these nations, and then spread to more nations in Europe. When there is such a “run” it is not clear where it stops.  In the hazy distance, Belgium, France, Austria and many others were potentially at risk.  Even the Germans cannot afford to bail out those nations.
Slapped in the face by this ugly scenario, the Europeans decided to throw everything they and the IMF had at bailing out Greece.   The program as announced has only a small chance of preventing eventual Greek bankruptcy, but it may still slow or avert a dangerous spiral downward – and enormous collateral damage – in the rest of Europe. 
The IMF floated in some fashion an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities.  This is not a surprise – leading European policymakers are completely unprepared for broader problems that would follow a Greek “restructuring”, because markets would immediately mark down the debt (i.e., increase the yields) for Portugal, Spain, Ireland, and even Italy.  The fear and panic in the face of this would be unparalleled in modern times: When the Greeks pay only 50% on the face value of their debt, what should expect from the Portuguese and Spanish?  It all becomes arbitrary, including which countries are dragged down.  Someone has to decide who should be defended and at what cost, and the European structures are completely unsuited to this kind of tough decision-making under pressure. 
In the extreme downside scenario, Germany is the only obvious safe haven within the eurozone, so its government bond yields would collapse while other governments face sharply rising yields.  The eurozone would likely not hold together.
There is still a narrow escape path, without immediate debt default and the chaos that would produce:
1.  Talk down the euro – moving towards parity with the US dollar would help lift growth across the eurozone.
2.  As the euro falls, bond yields will rise on the eurozone periphery.  This will create episodes of panic.  Enough short-term financing must be in place to support the rollover of government debt.
3.  Once the euro has fallen a great deal, announce the ECB will support the euro at those levels (i.e., prevent appreciation, with G20 tacit agreement), and also support the peripheral eurozone nations viewed as solvent by buying their bonds whenever markets are chaotic. 
4. At that stage, but not before, the eurozone leadership needs to push weaker governments to restructure – that will include Greece and perhaps also Portugal?  Hopefully, in this scenario Spain can muddle through.
5. European banks should be recapitalized as necessary and have most of their management replaced.  This is a massive failure of euro groupthink – including most notably at the political level – but there is no question that bank executives have not behaved responsibly in a long while and should be replaced en masse. 
To the extent possible, some of the ensuing losses should be shared with bank creditors.  But be careful what you wish for – the bankers are powerful for a reason; they have built vital yet fragile structures at the heart of our economies.  Dismantle with care.