Greece for Grownups

LONDON – Greece and its European partners may have agreed on a new bailout provision, but how the Greek economic tragedy will actually end remains a mystery. One thing, however, is certain: eurozone governments will end up writing off a large proportion of their loans to Greece. Their refusal to recognize that reality has increased the losses they will suffer.

To be sure, the Greek government has, at times, been provocative and unrealistic, failing to accept, for example, the need for serious pension reform. But the eurozone authorities’ refusal to accept the need for debt relief has been equally divorced from reality. Three weeks ago, International Monetary Fund Managing Director Christine Lagarde’s called for talks to resume “with adults in the room.” That means facing facts.

In this sense, the IMF’s latest Debt Sustainability Analysis, published on June 26, is a grown-up document. It makes clear that Greece’s debts will not be sustainable without further concessional loans and an extension of existing debt maturities; perhaps, it suggests, a write-off of some €50 billion ($55 billion) will also be needed. But even these calculations are based on unrealistic assumptions.

Previous bailout agreements presumed that Greece would run a primary budget surplus (before interest payments) of 4.5% of GDP pretty much permanently. The IMF has revised that assumption downward, to 3.5%. But this still ignores the reality that Greeks can walk away from their debts – not only metaphorically, by defaulting, but also literally, by migrating to Germany, for instance.

As long as Greece remains a member of the European Union, its taxpayers can walk away, just as Detroit’s did in the decades before its bankruptcy. If remaining in Greece means living in a country where taxes are always 10% higher than public expenditures, many – especially the young and talented – will do just that.

It has been clear for five years that Greece’s debts are unsustainable. It was also obvious that the private-sector debt write-down of 2012 would have to be followed by an official one. But the eurozone authorities refused to offer debt relief to the previous Greek government, and instead imposed more severe austerity than was necessary.

As a consequence, Greece’s recession deepened; its already-unsustainable debt swelled further; and the anti-austerity Syriza party rose to power. The prolonged uncertainty drove Greeks to withdraw their bank deposits, the cash for which came from the €90 billion of emergency liquidity assistance provided by the European Central Bank. That money will be re-denominated in devalued new drachmas if Greece leaves the eurozone.

In promising that Germany would suffer no debt write-off, Chancellor Angela Merkel made a promise she couldn’t keep. Worse, by maintaining that stubborn position, eurozone negotiators have ensured that the eventual write-offs will be even larger.

That negotiating position might still be rational if bigger eventual Greek write-offs would be offset by reduced write-offs elsewhere or at another time. After all, if Greece receives debt relief Ireland or Spain might demand the same, and all eurozone governments would have a weaker incentive to adhere to fiscal discipline in the future. A rational banker might deliberately provoke bankruptcy and suffer larger write-offs than necessary, in order to teach lessons and create better future incentives.

But Greece is not just another debtor. It is a potentially fragile state on the edge of a Europe that is facing a massive migration crisis and a dangerously nationalistic Russian leadership looking for opportunities to cause trouble. The eurozone must find a way to ensure future debt discipline, without provoking an even deeper crisis in Greece.

Even in the United States, imposing fiscal discipline on sub-federal entities is often difficult. However clear their non-guaranteed status, financially distressed cities or states – whether New York in the 1970s or Puerto Rico today – can put serious pressure on national political leaders to offer assistance. In the eurozone, the links between governments and national banking systems make market discipline even more difficult to achieve.

Imagine if one were to suggest that banks operating in Illinois should be required to hold large portfolios of Illinois state bonds, with their deposits insured by an Illinois state insurance scheme, and the Illinois state government responsible for recapitalization, if needed. The proposal would be dismissed as economic lunacy. In such a system, a recession would create a self-reinforcing spiral of deteriorating public finances, rising fears of bank insolvency, and declining credit extension. And yet, if you replace “Illinois” with Ireland, Spain, or Greece, that is how things work in the eurozone.

This system has made a market-based approach to addressing unsustainable debts impossible. Rather than risking write-offs of government or bank debt, eurozone governments and the ECB absorbed the debts that were initially extended by the private sector onto the public balance sheets of the eurozone’s member states. In Ireland and Spain, the private sector escaped scot-free. In Greece, there was some “private-sector involvement”; but many irresponsible lenders still managed to pass on their exposures to eurozone governments.

To ensure future fiscal discipline, the eurozone must disentangle its banks from national governments and create a true banking union. High equity requirements or tight quantitative limits should be used to restrict banks’ holdings of national government bonds; banks should instead hold liquid assets in the form of eurozone-level bonds, bills, or cash reserves at the ECB. And national public debt should be held by the non-bank private sector, which should suffer large write-downs if debt rises to unsustainable levels. The desirable effect would be that governments would find it harder to accumulate debts they could not afford.

But appropriate future reforms cannot change the fact that, today, Greece’s debts are unsustainable. Adult negotiators have to face two realities: large debt write-offs are inevitable, and punishing Greece further will not put the eurozone on the path to financial discipline. For that, systemic reform is essential.