2010 March 13 Saturday
Greece Still On Path Toward Debt Default

Peter Boone and Simon Johnson lay out arguments for why the Greek debt crisis is not in our rear view mirror.

By the end of 2011 Greece’s debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time – for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently).  About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany.  Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders. 

What if Greek interest rates rise to, say, 10% – a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called “austerity” program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe?  Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years). 

This is simply impossible and unheard of for any long period of history.  German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings).  Neither of these were good experiences.

Boone and Johnson say the Greeks and other European countries have got to decide whether they are willing to pay the price to keep Greece in the Euro currency zone. Without guarantees by Germany, France, or the IMF on Greece's debt the debt interest costs will go too high and Greece will default.

But I'm less clear on how abandonment of the Euro helps. A withdrawal of Greece from the Euro zone could happen before or after a default. If Greece withdraws then its debt servicing problem remains. Greece would still have lots of outstanding debt denominated in Euros and the Greek drachma currency would drop against the Euro - making payment of existing Euro-denominated debt even harder.

What's interesting about their claims: They portray the European leaders as deceptive for pretending that the crisis is easing. They see the basic financial numbers as so bleak that the crisis looks set to escalate.

Tyler Cowen calls the article a a grim but realistic report. Paul Krugman argues that if the markets were willing to treat Greece as a very low default risk then Greece could easily afford to pay much lower interest costs on 150% GDP debt. So the question becomes: Can Greece convince the markets to treat it as a low default risk? If the markets decide Greece is a high default risk then Greece really is a high default risk.

I see another problem here: How can the Greek government maintain popular support for the austerity measures needed to prevent even higher debt accumulation if the markets decide to treat Greece as a low default risk? Absent a crisis various political factions in Greece will push for more spending for their benefit. Then the market will once again see Greece as high default risk. Interest rates demanded on new Greek debt issues will force Greece back down the path toward default.

Update: Sounds like the Eurozone countries will bail out Greece after all.

Plans for a bailout for Greece totalling €20 to €25 billion will be put to a meeting of Eurozone finance ministers on Monday.

A system of co-ordinated bilateral moves has been agreed behind the scenes by major players among the 16 countries in the single currency, led by Germany. They will step in as a last resort if Greece requests help in meeting its huge sovereign debt repayments.

The package has been formulated to work around a "no bailout" clause in EU rules, and would amount to an agreement to facilitate loan guarantees if Athens finds the price of selling its debt pushed too high by speculators.

But this doesn't kick in immediately. The goal here appears to be to discourage the markets from driving up the interest rate of new Greek debt issues.

Update: Simon Johnson says the European mandarins want to prevent the International Monetary Fund from bailing out Greece.

Wolfgang Schauble, German finance minister, has a surprisingly sensible op ed in today’s Financial Times.  As we suggested yesterday, first the relevant Europeans should decide if they want to keep the euro - more precisely, who stays in and who leaves the currency union – then policy must be adjusted accordingly.

Mr Schauble is obviously correct that existing economic self-policing mechanisms are badly broken; the eurozone can only survive if there are effective monitors and appropriate penalties for fiscal and financial transgression.  He is also right to fear that involving the IMF in Greece would necessarily give the Fund greater rights to kibbitz on European Central Bank monetary policy.  Given the fear and loathing expressed for the IMF’s “4 percent inflation solution” (or is it 6 percent?) in eurozone policy circles, you can see why this gives the Greek prime minister some bargaining power – the Germans will do whatever it takes to keep him away from the IMF in the short-term.

If the Greeks do not get bailed out and the market senses they are going to default then the EU's rules allowing free movement of capital will allow a huge flight of capital out of Greece due to fear that Euros will get converted into Drachma. If I was a Greek right now I'd be opening a bank account outside of Greece and maybe even outside of the EU. Time to get money out of the reach of a desperate government.

Share |      By Randall Parker at 2010 March 13 01:45 PM  Economics Sovereign Crises

Stephen said at March 13, 2010 10:25 PM:

The problem is that the market isn't rational, instead its a mob. If they take a dislike to you then you're screwed.

We need to create market signals that disadvantage mob behaviour. Perhaps slow down the velocity of money, make it more sticky, with a tax on every trans-national transfer - that expense might make a speculator think before reacting. Another thing I'd do if I were global emperor for a day is place an minimum age on money market dealers - no more cocaine snorting 20-somethings, instead have 45yo+ people with broader life experiences. Hopefully the combination of life experience and age will make them less inclined to run with the mob.

theag said at March 14, 2010 4:14 AM:

"Paul Krugman argues that if the markets were willing to treat Greece as a very low default risk then Greece could easily afford to pay much lower interest costs on 150% GDP debt."

Then why doesn't the EU simply order it done? It's not as if there are any moral or legal restrictions that keep the EU controlled banks from offering Greece money at any interest rate they choose. Even better, why not choose a negative interest rate, say -1%? Then the problem would simply disappear after a time.

no i don't said at March 15, 2010 1:55 PM:

Greece still?

Randy, you really need to freshen up this blog a bit. I mean, seriously.
This is beginning to put people to sleep. Give us something fresh.

At least those dull stereotypes and frisky insluts of some pseudo-nazis here were a little more entertaining.

blue monkey said at May 9, 2010 6:35 AM:

Greece and Spain won't pay back. This was a calculated Risk, and a Lesson for the Banking System. The only thing Germans can do is:
REPOSSESS 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
U.S.A must REPOSSESS 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.
Don't worry; the ECB, the Fed or both will print the money.
And all of us will share the pain, with our hard-earned money.
Bad is never good till the worse happened.

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