Two years ago a senior German diplomat told me his fear to see the European and German flags burned on the streets of Athens. The increasingly acrimonious tone of the Greek debate and the riots on Syntagma Square indicate that he was right. When they decided in spring 2010 to take a leading role in conditional financial assistance to countries in crisis the EU, and the major member states within it, entered a game for which they were not prepared and that can have far-reaching consequences.
This dimension should not be ignored when discussing what strategy to adopt to address the Greek budgetary predicament. The current thinking among European officials is that Greece should first adjust to stabilise its debt-to-GDP ratio and then embark on a sustained effort to reduce it. Belgium, it is sometimes said, did it in the 1990s. Why not Greece?
According to European Commission forecasts, the Greek public debt ratio is set to reach 166 per cent of GDP next year. Even assuming a swift privatisation programme (hardly a safe bet), it will still be of the order of magnitude of 150 per cent of GDP. A frightening number, because to reduce this ratio to a level at which creditors would willingly lend, the country will need for many years to keep non-interest spending way below tax receipts – a recipe for citizen anger. Large-scale tax evasion and a sentiment of unfairness in the distribution of the burden already result in public tolerance to higher taxes reaching its limits, although tax receipts are still below to non-interest spending.
True, Belgium in 1993 reached a debt ratio of 134 per cent of GDP and was able to bring it down to 84 per cent in 2007. This comparison, however, ignores important differences. To start with, Belgium in 1993 had a reasonably effective state and a reasonably fair tax system. Second, in the ten following years it grew at close to 4 per cent per year in nominal terms: not stellar, but enough to help reduce the load of outstanding debt. Third, over the same period interest rates on the debt declined from the 8 per cent inherited from the inflationary years to some 5-6 per cent. Under these conditions a lasting excess of tax receipts over non-interest spending of about 5 to 6 per cent of GDP – not a trivial achievement by international standards – was enough to bring about steady debt reduction.
Greece unfortunately cannot hope to grow fast. Official projections envisage reaching four per cent nominal growth from 2015 onwards, but the country starts from a very uncompetitive position and it needs to keep inflation way below euro area average if it wants to restore competitiveness. Success on that front implies slower nominal growth and, for this reason, an aggravated debt problem. Moreover, Greece benefitted over the last ten years from favourable interest rates. Borrowing costs as now set to increase. Obviously it cannot tap the markets under current conditions, but assuming it would entirely rely on official assistance and a maturity extension on part of its outstanding debt claims, as recently proposed by French banks, this would over time result in an increase of debt costs.
So what can be done? There are only two economically consistent options. One, call it Plan A is to socialise the Greek debt. It requires guaranteeing Greek debt and/or lowering the interest rate on official assistance, so that the average debt cost is low enough to make Greece solvent. As some form of subsidy will be inevitable, this plan also implies deciding who will bear the corresponding cost – either the banks, through a special levy or, by default, the ordinary taxpayers. The other strategy, Plan B, is to make private creditors pay through an orderly restructuring. The obstacle here is the fear of consequences for financial stability. To make it a viable option, preparations must be undertaken, not least by the ECB, so that when restructuring takes place its financial fallout can be contained.
Each plan is anathema to some of the European leaders, but one will eventually have to be chosen. The more time goes by, the closer Europe gets to Plan A, for the simple reason that official creditors gradually substitute private creditors. Even if the scheme put forward by French banks was implemented in full, private creditors would only roll over half of outstanding bonds coming due. The other half, and all new debt, would be financed by the IMF and the EU member states.
So the Europeans will eventually have to decide whether to insist, in spite of contrary evidence, that Greece can follow the Belgian route, or to accept subsidising it. The more likely scenario is that they will stick to the current stance for as long as they can. At some point however the Greek citizens will realise that they are transferring a significant fraction of their income to wealthier European sovereigns in the form of interest payments (Commission forecasts indicate that interest on the public debt should already reach 7.5 per cent of GDP in 2012). At this point, if not before, the politically sustainability of the whole scheme will be put into question.
With the German reparations, Europe in the interwar period experienced ad nauseam how divisive and ultimately poisonous inter-state financial quarrels can be. Perhaps the best advice to the European officials as they prepare for the holidays season is to take to the beaches the excellent Lords of Finance, Lords of Finance, by Liaquat Ahamed. It is entertaining, illuminating, and sobering.