A Default by Greece: Why and When?
The $1 trillion rescue of the eurozone, aimed at averting a spread of contagion from Greece, did nothing to help the Greeks address their underlying and unsustainable fiscal situation. Greece is insolvent and needs to lower its total debt burden before 2012.
As I wrote earlier, the IMF has published its detailed economic analysis [pdf] of the Greek restructuring program, highlighting the substantial risks even under the IMF's own somewhat optimistic economic assumptions. The IMF's numbers indicate, for example, that even with the bailout package from the eurozone and the Fund, Greece is expected to cover part of its public financing need through a rollover of short-term debt in the private financial markets as soon as next month. Moreover, the IMF also envisions that Greece will be able to roll over long-term debt as soon as Q1 2012, at a time when Greece is expected to have a total debt burden of 145 percent of GDP. These steps will almost certainly prove impossible at low interest rates necessary for Greece to keep its primary deficit from exploding. The IMF itself assumes in its baseline scenario a 1 percent primary surplus in 2012 and total Greek interest payments of 7.5 percent of GDP—i.e., an implied cost of refinancing of 5 percent or so for 145 percent of GDP of debt.
Even if everything else goes right for Greece until then, that is just not credible and illustrates that Greece will need to reduce its total debt burden before 2012, even under the IMF's own baseline scenario.
In theory such a reduction can be carried out in six ways, as described in Buiter (2010, 21ff). The problem is that only one is actually available to Greece.
First, eurozone governments could continue to bail out Greece in perpetuity after 2012, removing the need for the country to reduce its debts. Of course this would produce extraordinary moral hazard and is consequently politically unthinkable. The fact that the newly created €440 billion eurozone facility is also initially a three-year facility (subject to permanent institutionalization via negotiations among eurozone members and other EU institutions) suggests that no more official sector money will flow to Greece after 2012.
Second, a country with its own monetary policy could use a bout of unexpected inflation to reduce the real value of its debts, but this is not an option for Greece as a member of the eurozone.
Third, rapid economic growth could lower Greece's debt burden. But even with the considerable structural economic reforms envisioned in the IMF program, an "Aegean Tiger" growth scenario would very likely be doomed by Greece's demographic outlook, with a labor force projected to start a long-term decline this year (2010) and drop by a quarter by 2050.1
Fourth, Greece might somehow be able to lower the interest payments on its debt. However, as illustrated in recent weeks, persistent default risk premiums for Greece and its continuing reliance on foreign financing makes a "Japan scenario" of high public debts and low interest rates extremely difficult, even if it achieves decent growth in the years ahead. More likely, it is too late for the Greek government to suddenly begin financing its debt through private domestic savings, like Japan.
Fifth, there is the IMF and eurozone preferred "fiscal consolidation option," successfully pursued by Ireland, Latvia, and now possibly Spain and Portugal. But these countries enjoy lower debt stocks at the start of their consolidation. Even their large contractions in GDP did not cause their debt-to-GDP ratios to reach unacceptably high levels. Greece's debts are too big for it to succeed in going down this path.
With all these paths unavailable, default is the likely outcome for Greece. The main question is what form it will take.2 What is the most probable and most painless outcome?
As discussed previously here, $1 trillion sovereign commitments toward eurozone stability by EU member states and the IMF, combined with the European Central Bank actions on Sunday, went a long way toward addressing the two principal channels of contagion from a Greek default. As a result, a Greek default is less risky than before and should therefore be more palatable for eurozone governments and the IMF – not necessarily now, but at some point in the future. In that sense, the key accomplishment of last weekend's deal was, in the words of my colleague Michael Mussa, "Not now!"3
It should also be clear that as a member of the European Union—with its deeply institutionalized regional integration and rigorous surveillance program carried out by Eurostat—it would be next to impossible for Greece to surprise its partners and creditors with a sudden declaration of default, as Russia did on its domestic debts in 1998. Considering the fact that for Greece, with most of its debts held by foreigners (over 80 percent according to the Bank of International Settlements), a sudden unilateral declaration of default would, while transferring the financial costs abroad, prove extremely costly for Greece politically. This would especially be true in light of the political and financial resources already committed by the eurozone and the IMF. Greece's "political pariah" status would be sealed for many years even if its exclusion from financial markets lasts only the 5 to 7years that Rogoff and Reinhart describe as normal.
It is further clear, as described by Michael Mussa,4 that countries that go into a default will want to make sure that they only do so once. To eliminate any risk that another additional default might be necessary in the future, Greece would have to go for a very large haircut on its debt stock—probably 50 to 70 percent would be required. Considering that the IMF and eurozone funds now flowing to Greece have "super preferred creditor status" in legal and/or political terms, very little would be left for private creditors.
In fact eurozone governments have a "perverse political incentive" to accept a Greek default, especially if it can be carefully negotiated. If they do not do so and impose significant haircuts on their own banks (but obviously not so large that these banks need another government bailout themselves), they will once again in effect have bailed out their irresponsible bankers with taxpayer money and will suffer a political backlash.
The fact that in Germany private banks voluntarily agreed to retain their exposures (€8.1 billion) to Greek debt shows the lengths to which they were willing to go to avoid being seen as "benefiting again from taxpayers' generosity."
What is politically needed for eurozone governments is a "Pigovian haircut" on Greek debt5 —just enough to put Greece back on a sustainable long-term cause AND wipe out bankers' bonuses in the process, but not enough to force these banks into insolvency.
Similarly, eurozone governments need to lean on their banks forcefully to get them to raise substantial amounts of new equity capital to withstand losses from a potential Greek default (and punish existing shareholders and management by diluting the value of their shares). The suggestion by Mayer and Gross to a eurozone-wide stress test to gauge individual exposures to sovereign risk could play a constructive role here, too, in easing uncertainty about the solvency of eurozone banks in a Greek default.
As described by Buiter (2010) the rationale for a country, especially one with a large outstanding foreign debt like Greece, is to default on its debts at the time when its primary surplus is zero. According to the IMF, the moment of default could arrive in 2012. At this point, Greece will have accomplished sufficient fiscal austerity to reduce its overall budget surplus to zero, if only it had no interest payments to make. (In a country with no government debt or interest payments the primary surplus position by definition equals the regular budget position.) Through a default on its debts, the Greek government would not have to implement additional austerity measures to finance large interest payments to (largely foreign) creditors, and would have balanced its books this way with less domestic pain. Meanwhile, it is clear that at least for every Greek under the age of 35, the incentives are extremely strong to default soon to avoid being stuck with the bill for their parents' excesses. The generational warfare aspects of this throughout the Mediterranean are very pronounced.
Delay in initiating negotiations about who pays what and when is risky, however. A ruling on the legality of the euro rescue could come from the German Constitutional Court. A negative ruling could complicate matters tremendously. By 2012 there will be little additional official money left to provide an incentive to Greece to enter into such negotiations. From the perspectives of private creditors, the longer the delay, the more that official sector "preferred creditor debt" on the Greek books piles up—leaving little left for junior creditors.
The "Goldilocks Greece default" time—not too soon, not too late—would therefore seem to be after a credit evaluation of the eurozone banking system is complete and any potentially required additional capital successfully has been raised. And after Spain and Portugal (and other eurozone governments) have had sufficient time to take painful preemptive additional austerity measures and convince financial markets that they are "not another Greece".6 But before the German Constitutional Court rules—and long before the end of the three-year program. Probably around six to nine, and at most 12, months from now.
2. Default here includes any kind of noncompliance with the original terms of the debt contract, like repudiations, standstills, moratoria, restructurings, or reschedulings, though each of these might well come with different psychological effects on the markets. See Buiter (2010, 21).
3. Comments at internal Peterson Institute staff discussion, May 7, 2010.
5. In economic terms, a "Pigovian tax" is levied on market transactions that produce "negative externalities" whose social costs are not included in the price of the market transaction. The Pigovian tax alters the market outcome and lowers the inefficient overconsumption of the "good with negative externalities," restoring market efficiency in the process.
6. This week, with the political shifts in Madrid and Lisbon toward politically painful austerity measures, we have started to see how this "See, we are not Greece" process will work for other vulnerable eurozone countries.