The Greek debt trap: missing the wrong target

by Zsolt Darvas on 15th November 2012

IMF and European officials have publicly clashed over the date by when Greece public debt should be reduced to 120 percent of GDP. The IMF insists on the earlier target date of 2020, while the Europeans propose 2022. Both are wrong: a 120 percent target, whether it is reached in eight or ten years, will not restore trust now and will not make investments in Greek bonds attractive to private investors a decade from now. A credible strategy should involve zero-interest official lending and indexing loans to GDP.

A major reason for Greece's public debt misery is a negative feedback loop between high public debt and the collapse in GDP. The loop is especially strong when there are widespread expectations of a Greek euro exit. The prospect of euro exit discourages private investment and increases incentives for tax evasion and capital flight, thereby dragging growth down and worsening the fiscal situation. As the budget deficit and debt ratio increase, the official lenders are demanding additional fiscal consolation measures, which further drag down output.

A point may come when the Greek government and parliament may be unable or unwilling to pass new measures, perhaps because of social unrest. That could lead to a collapse of the government, domestic political paralysis and the stopping of external financial assistance. Without external financial assistance, the Greek state may default, which could culminate in an accelerated and possibly uncontrolled exit from the euro area, with devastating consequences both inside and outside Greece.

Therefore, restoring public debt sustainability, and thereby resisting euro-exit speculation, is a necessary (though not sufficient) condition for stopping further economic contraction. The 120 percent of GDP target by 2020 has proved to be inadequate for restoring trust and thereby limiting the probability of a Greek euro exit. A reiteration of the same target, or its extension to 2022, is unlikely to help. That would just prolong economic and social misery and the uncertainty about Greek euro membership.

A strategy leading to a credible resolution of the Greek public debt overhang would benefit both Greece and its lenders. Such a strategy should involve a maximum 100 percent of GDP debt ratio target by 2020, along with a safeguard that would minimise the probability of a similar debt overhang occurring later. The measures currently under discussion, such as a small reduction in the interest rate on bilateral loans, the exchange of European Central Bank Greek bond holdings, or buy-back of privately-held Greek debt, won’t be enough.

While these measures should be tried, the main plank of the strategy should be the reduction of the official lending rate to zero until 2020. In its effect this official sector involvement would be similar to a write-down of the debt, but could be perhaps politically more acceptable. The second plank of the strategy should be the indexing of the notional amount of all official loans to Greek GDP. This would help to avoid a repetition of the current situation should growth disappoint further. But if growth is better than expected, official creditors will also benefit.

Since the Greek financing programmes were designed by the troika of the European Commission, ECB and the IMF, and were approved by euro-area member states, responsibility for programme failure should be shared between all lenders and the Greek government. Therefore, there should be no reason for excluding any of the official lenders from the debt restructuring and hence the IMF and the ECB should also share the burden. The ECB cannot participate directly because of the strict prohibition of monetary financing by the EU Treaty, but this is not an obstacle: the ECB’s interest income from Greek bonds will be ultimately transferred to euro-area member states, which should grant this interest income to Greece.

At the same time, all efforts should be made by Greece to pay back the debt relief provided via the zero-interest lending (realistically, beyond 2030). Greece should commit to a stable primary budget surplus in the long run (say, 3.5 percent of GDP) and that commitment should be enforced, possibly by curtailing further Greece's fiscal sovereignty. Then the debt ratio will fall further. When the debt falls below a certain threshold, such as 60 percent of GDP, then Greece should not reduce the debt ratio further, but gradually pay back the debt relief. An extended privatisation plan could also be used to pay back the debt relief, though there are major uncertainties even about the current privatisation plan.

Policymakers have to recognise the failure of their current Greek strategy and decide if they wish to keep Greece inside the euro area or push it out. If they want to keep Greece in, which I hope they do, then they need to change course and not just implement some easy measures, grant some extra money and prolong by two years the anyway inadequate debt target of 120 percent of GDP. That would backfire soon.

The author is research fellow at Bruegel and author of the report ‘The Greek debt trap: an escape plan’.

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