The Greek tragedy: what next?

With reference to the latest Weekender,

Thanks Shahin for this nice piece (again!) and for incorporating some of our comments to the earlier draft.

I was always sceptical about the relief that a voluntary private sector involvement (PSI) may bring and argued for an orderly debt restructuring as a part of a comprehensive solution, which should include proper provisions for Greek banks, as you also argue, and for banks of other euro-area countries, better European safety nets and a growth programme (see the comprehensive plan proposed in the policy brief A comprehensive approach to the euro-area debt crisis from February 2011,  the policy contribution Debt restructuring in the euro area: A necessary but manageable evil?  from June 2011, and the column The Greek public debt misery: the right cure should follow the right diagnosis from October 2011). In this sense we have converged.

There are two major points of disagreement between us. One relates to need for haircut for official lending and the other relates to the consequences of a Greek default and the call for capital controls.

1. Total Greek public debt was €347bn in September 2011 of which the IMF and bilateral euro-area lent about €80bn. The rest, ie approx. €270bn, was with the private sector and the ECB. In my view the ECB should face the same loss as private bondholders (otherwise, the ECB would be seen as a preferred creditor and hence its government bond purchases could be destabilising). There are not only private bondholders, but also private creditors of loans and they should be considered as well. Unfortunately it is very difficult to obtain information on private loans to the Greek general government. Were these loans granted by Greek banks (which need new capital in the event of a default)? Were these loans granted, at least partly, to local governments and state owned enterprises (which may need different treatment than the central government debt)? Yet we cannot exclude that a sufficient reduction in the approx. €270bn debt held by private creditors and the ECB would decrease the debt/GDP ratio to a level well below 100% percent of GDP soon, which should be the target. (Indeed, the current plan with the voluntary PSI to achieve a 120% debt ratio by 2020 will clearly not solve the problem.) We should call for a debt reduction in official loans only once we know for sure that a sufficient reduction in privately and ECB-held debt is not possible. But even then, for political reasons, I would avoid a direct haircut and would instead propose further lowering of the interest rate possibly to zero, suspension of debt amortisation for a decade, etc.
2. I always had the view that a proper debt restructuring may not have such a devastating impact on the rest of the euro area as it is frequently assumed – when proper safeguards are put in place (see the pieces above). And I always had the view that debt restructuring should be organised within the euro area and Greece should not exit. You are right that in case Greek banks would not be supported, the outcome could be a Greek exit from the euro. But I think the probability of this happening is very small – much smaller than your text suggests. There are reasons concerning both Greece and the rest of the euro area. Concerning Greece, analysts from UBS have recently concluded that a weak country leaving the euro area would lose about one half of its GDP in the first year – I think they are right. That would necessitate even harsher fiscal austerity, since it is not very likely that in the event of a messy exit from the euro other euro-area partners would be happy to lend to Greece – without that, the Greek government could spend only tax revenues, which would be dramatically reduced by the collapse of GDP. And there would be longer term consequences as well, since the low credibility of the newly stand-alone Greek central bank would likely lead to much higher real interest rates as well as to a period of high inflation, which are bad for growth. Also, a euro-exit may be accompanied by an EU-exit and thereby Greece would give up huge transfers form the EU. Consequently, it is still better for Greece to stay inside the euro area even if the struggle will continue for many years, if not decades. It is also the best interest of euro-area partners to keep Greece inside. In addition to losses of both official and private lenders of the Greek government, foreign lenders of the Greek private sector would also suffer massive losses (most Greek private companies would also go bankrupt, hurting various financial and trade relations). But perhaps even more importantly, a Greek exit would open Pandora's box and it would be very difficult to safeguard other weaker countries, such as Portugal and Ireland, even if capital controls were introduced as you suggests. If an orderly default is organised for Greece inside the euro area, contagion could be limited and the ‘final solution’ could even restore confidence to some extent. At the same time euro-area partners should put together a real programme for supporting Greek growth.