«The optimal intervention is an assistance program providing debt relief and a transfer flow continuing until the end of the recession, when the country is charged a relatively high interest payment. »
The Greek debt crisis has regained salience after the landslide electoral victory of Syriza. German politicians, backed by a frustrated local public opinion, promise to take a strong stand against any attempt to renegotiate the existing agreements. Is there a way out of this never-ending havoc?
In the policy debate, one hears two apparently irreconcilable positions. The hawks maintain that debt must be enforced, and that no further concessions can be granted to Greece. In particular, many German economists and politicians argue for zero tolerance towards promise breaking behavior. Beyond the direct costs, a soft response would undermine the credibility of markets and institutions, creating a widespread moral hazard problem. Other countries would soon imitate Greece and the incentives to make necessary structural reforms would vanish all over Southern Europe.
The doves argue that austerity is the root of the problem rather than its solution. They note that Greece has already gone through a painful adjustment including a drastic reduction of public expenditure. However, austerity has only brought devastating social costs, including an unemployment rate above 25%. Instead, there is no sign of growth recovery. In the current situation, the outstanding debt level is simply unsustainable, and insisting on enforcing repayment is both meaningless and against basic principles of inter-European solidarity. They remind Germany of the London Debt Agreement of 1953, when creditors granted the Federal Republic a major debt relief.
Fruitless debate between haks and doves
Both positions, in their partisan nature, miss important pieces of the problem. The hawks should be reminded that the default risk was incorporated into the price at which Greek debt was sold. For instance, in April 2014, the Greek government borrowed from the private markets by issuing a five-year government bond with a yield close to 5%. Investors knew that this was not a safe asset, as reflected in the price at which they bought it. Therefore, it becomes difficult to maintain now that that debt must be fully honored as a matter of a Kantian categorical imperative. Second, the democratic process sets limit to how harsh an adjustment can be imposed on indebted countries – as the recent Greek elections has shown. Denying this is either propaganda or self-deception. This awareness is also priced into the debt. In a sense, investors were taking a chance hoping in a fast recovery that did not materialize. Third, too harsh an approach may be self-defeating. A common argument from the hawks’ side is that a painful austerity is necessary to induce indebted countries to swallow the hard pill of economic reforms.
However, economic theory and evidence show that at very high debt levels, the opposite may be true: indebted economies may enter what economists call “debt overhang”. Namely, the government realizes that debt is unlikely to be repaid if the recession continues, but will be paid if there is economic recovery. This means the part of the benefits of successful (but painful) structural reforms would accrue to creditors in the form of a high probability of debt repayment. In this scenario, the support for costly economic reforms wanes, and cutting the debt would actually increase the support for structural reforms.
The doves’argument is also overly simplistic. The cancellation of part of the debt may offer some relief, but what would come next? Greece has already benefited from a significant debt haircut in 2011. In spite of this, the external exposure of Greece has quickly soared again to unsustainable levels. Expecting that the EU will accept to make indefinite transfers to Greece is illusory. Where would Syriza’s government find the resources to finance the ambitious expenditure programs it proclaims? Borrowing from the market would by outrageously expensive. Of course, in an extreme scenario Greece could leave the Euro area and regained control over its monetary policy. However, this would be a mixed bliss. It could of course resort to finance government expenditure by printing money. It is well understood where this approach would lead: hyperinflation and the ruin of the middle class, like Yugoslavia in 1994 and Zimbabwe in 2008. The government would have hard time in surviving to the ensuing social turmoil. In summary, announcing major expenditure plans may help win an election, but is no solution either.
Way of compromise
A third way is that of pragmatic compromise. Pragmatism is often portrayed as the terrain of practitioners, in contrast with principle-based theory. In recent research at the University of Zurich (joint with Andreas Müller and Kjetil Storesletten) we show that in this occasion pragmatism is actually rooted in the predictions of sound economic theory. We study the efficient way to handle a debt crisis involving an economy struggling with a persistent recession. Our macroeconomic model embeds two important features. First, countries can renege on their sovereign debt whenever the cost of doing so (including political costs, goodwill relations, sanctions etc.) fall short of the benefits (non-repayment).
The perception of the costs of reneging may vary across political parties. For instance, they may been higher for New Democracy than for Syriza, and this can confer Syriza a stronger bargaining power at the international level. Second, socially costly structural reforms reduce the expected duration of the recession. In this environment, the country can finance its expenditure by issuing debt. However, the interest charged by the market on debt increases with the probability of default, which is in turn increasing with the outstanding debt level. Whenever a country poses a credible threat to default, creditors can offer the country to renegotiation its debt at improved terms, which takes the form of a debt haircut or an interest reduction.
In this environment, we find that the market does not achieve an efficient outcome. The welfare cost associated with the market failure is significant. The country has an incentive to issue too much debt and to shirk on reforms, and is punished by the market in the form of very high interest rate. Debt run-up and subsequent defaults happen too frequently, and the recession lasts too long relative to the benchmark of an efficient allocation. We show that the well-designed intervention of an external agency (e.g., the Trojka) can increase the welfare of both the country and the creditor. The optimal intervention is an assistance program providing debt relief and a transfer flow continuing until the end of the recession, when the country is charged a relatively high interest payment.
In favor of a flexible agreement
The efficient arrangement has two important conditions. First, the country is not allowed to expand its debt unilaterally, i.e., an austerity plan is imposed. Second, the agency is granted power to monitor the process of structural reform. This part is in line with the hawks’ recipe. However, our dynamic theory also prescribes that whenever the debtor can threaten credibly to abandon the program, due for instance to a political shock such as the victory of a radical party like Syriza, the terms of the agreement must be renegotiated in its favor. In particular, the country must be offered a more lenient repayment structure (e.g., lower interests, or even a reduction of the face value debt), and softer demands in terms of economic reforms. This course of events (including the possible future renegotiations) was taken into account when the first deal was signed.
This prescription is different from the language currently spoken by Brussels and Berlin. Some politicians appear to believe that only a tough stand or even a resounding lesson to Greece can solve the problem. Our conclusions are quite different. The risk is that, in the name of misconceived economic principles, the outcome imposes large welfare losses on both Greece and the future of the European Union.