Greece is solvent but illiquid. What should the ECB do?

One feature of the Greek sovereign debt crisis, which is widely misunderstood, is the following. Since the start of the crisis the Greek sovereign debt has been subjected to several restructuring efforts. First, there was an explicit restructuring in 2012 forcing private holders of the debt to accept deep haircuts. This explicit restructuring had the effect of lowering the headline Greek sovereign debt by approximately 30% of GDP. Second, there were a series of implicit restructurings involving both a lengthening of the maturities and a lowering of the effective interest rate burden on the Greek sovereign debt. As a result of these implicit restructurings, the average maturity of the Greek sovereign debt is now approximately 16 years, which is considerably longer than the maturities of the government bonds of the other Eurozone countries. These implicit restructurings have also reduced the interest burden on the Greek debt. The effective interest burden of the Greek government has been estimated by Darvas of Bruegel to be a mere 2.6% of GDP. This is significantly lower than the interest burden of countries such as Belgium, Ireland, Italy, Spain and Portugal.

As a result of these implicit restructurings the headline debt burden of 175% of GDP in 2015 vastly overstates the effective debt burden. The latter can be defined as the net present value of the expected future interest disbursements and debt repayments by the Greek government, taking these implicit restructurings into account. Various estimates suggest that this effective debt burden of the Greek government is less than half of the headline debt burden of 175%.

From the preceding it follows that the effective debt burden of the Greek government is lower than the debt burden faced by not only the other periphery countries of the Eurozone but also by countries like Belgium and France. This leads to the conclusion that the Greek government debt is most probably sustainable provided Greece can start growing again (so that the denominator in the debt to GDP ratio can start increasing instead of shrinking as is the case today). Put differently, provided Greece can grow, its government is solvent.

The logic of the previous conclusion is that Greece is solvent but illiquid.  Today Greece has no access to the capital markets except if it is willing to pay prohibitive interest rates that would call into question its solvency. As a result, it cannot rollover its debt despite the fact that the debt is sustainable.

There is something circular here. If Greece is unable to find the liquidity to roll over its debt it will be forced to default. The expectation that this may happen leads to very high interest rates on the outstanding Greek government bonds reflecting the risk of holding these bonds. As a result, the Greek government cannot rollover its debt except at prohibitive interest rates. The expectation that the Greek government will be faced with a liquidity problem is self-fulfilling. The Greek government cannot find the liquidity because markets believe it cannot find liquidity. The Greek government is trapped in a bad equilibrium.

What is the role of the ECB in all this? More particularly, should the OMT-program be used in the case of Greece? The ECB has announced sensibly that OMT-support will only be provided to countries that are solvent but illiquid. But, as I have argued, that is the case today for Greece. So what prevents the ECB from providing liquidity? There is a second condition: OMT support is only granted to countries that have access to capital markets. This second condition does not make sense at all, because it maintains the circularity mentioned earlier. Greece has no access to capital markets (except at prohibitively high interest rates) because the markets expect Greece to experience liquidity problems and thus not to be able to rollover its debt.  

The explicit aim of the OMT-program was to prevent such self-fulfilling expectations that can push countries into a bad equilibrium. It is appropriate to quote Mario Draghi when he announced the OMT-program on 6^th September 2012: “The assessment of the Governing Council is that we are in a situation now where you have large parts of the euro area in what we call a “bad equilibrium”, namely an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse scenarios. So, there is a case for intervening, in a sense, to “break” these expectations”[1] Greece today fulfills the conditions for liquidity support as spelled out by Draghi in 2012. Yet Greece is excluded from this support, and as a result it is kept in a bad equilibrium.

The use of OMT to provide liquidity support to Greece is made difficult by the fact that public authorities hold the largest part of the Greek debt. To solve this problem it would be necessary that these public authorities recognize that the market value of their claims on Greece debt is worth a fraction of the nominal value. These public claims could then be sold in the market at a price that comes close to the net present value of the future disbursements (interest plus capital). At that moment the ECB could extend its OMT-promise to these assets (bonds) thereby creating a market for them.

I am aware that this solution creates a political problem. Governments of the creditor countries will have to recognize the losses they have already made on their claims on Greece. Politicians prefer to live in a fictional world allowing them to pretend no losses have been made so that they can hide the truth to their own taxpayers. The solution proposed here forces these governments to come out with the truth, i.e. the losses have already been incurred. I conclude that providing liquidity to Greece is possible provided governments stop hiding the truth.

All this teaches us two lessons. First, the objectives of the creditor nations, including the ECB, that today add tough conditions for their liquidity support is not to make Greece solvent but to punish it for misbehavior. The punishment is deemed to be necessary to avoid moral hazard risk. It is perfectly understandable that creditor nations are concerned about moral hazard. But it is precisely the desire to punish Greece by imposing additional austerity that makes it so difficult for Greece to start growing again and to extricate itself from the bad equilibrium.

A second lesson concerns the credibility of the future use of OMT.  It clearly appears from the Greek experience that the willingness of the ECB to use the OMT program is very circumscribed. It is circumscribed by the ECB’s desire to solve a moral hazard problem. The ECB seems to be saying that OMT will only be used when it can be certain its liquidity support will not trigger misbehavior. And this can only be achieved by imposing tough conditions. Behind the gloves of OMT is hidden a big stick. It is doubtful that future governments that experience payment difficulties will accept to be beaten up first before they can enjoy the OMT liquidity support.

Now that the European Court of Justice has given the legal clearance for OMT, the question arises whether the moral hazard hurdle to the use of the OMT will easily be overcome. I conclude that the credibility of the OMT-program to be used in times of crises is limited.

---

[1] http://www.ecb.europa.eu/press/pressconf/2012/html/is120906.en.html

Are creditors pushing Greece deliberately into default?

The Greek drama has entered its endgame. The Greek government has to repay loans to the IMF and other public institutions in the near future but does not have the cash to so. The lenders refuse to come forward in providing liquidity as long as the Greek government does not accept the conditions they impose.

We now hear from the finance ministers that the Greek government is unreasonable because it does not want to accept these conditions. These are that austerity be fully implemented and that the structural reforms that have been agreed to by the previous Greek government, be fully carried out.

But are these conditions reasonable?

The austerity measures that were imposed since 2011 led to devastating effects on the Greek economy. They drove millions of people into unemployment and poverty, and produced intense political instability that is responsible for the rise of Syriza. Insisting on further austerity does not seem reasonable when the failures of this strategy have become so obvious. The surprising thing is that ministers of finance continue to hold the moral high ground and preach to the Greek that they should be more reasonable. Being reasonable is equated to accepting the conditions of the creditors even if these conditions have failed to produce positive results. It is even more surprising that most of the media have now accepted this story.

Some of the structural reforms the creditors insist on are badly needed. Tax reform that would lead the rich to pay taxes, is one. But surely this is a reform that the Tsipras government, in contrast to the previous government, is willing to introduce. But other structural reforms are patently unreasonable. The privatization program that was agreed with the previous government and that the creditor nations insist should be implemented does not make sense. A country should not be pushed into disposing of its valuable assets in a forced fire sale. This will lead to very low revenues for the Greek government and will mainly profit the buyers, some of which are companies in the creditor nations.

We are now being told that the responsibility for failure rests entirely with the Greek government that remains unreasonable and unreliable. It is exactly the opposite. The intransigence of the lenders and the unreasonable demands they impose on a country are responsible for the drama that unfolds.

There is a big contradiction in this intransigence. As is well known, Greece has profited from debt rescheduling in the recent past. Maturities on the debt were extended and interest rates were lowered. According to the Brussels think tank, Bruegel, the effective Greek public debt represents only about 60% of Greek GDP. This appears to be sustainable, provided the Greek economy can function normally. Put differently, Greece can be said to be solvent but illiquid.

The lenders, however, keep the money tap closed. As a result, financial markets are now speculating that the Greek government will not be able to respect the next repayment deadline and will be forced to go into default. The interest rates on Greek government bonds have shot up to levels that make the debt service unsustainable and that make it impossible for the Greek government to refinance itself in the bond market. Speculation has become self-fulfilling and is driving the Greek government into default. But note that this is the outcome of the decision of the creditors not to provide liquidity to the Greek government. It is precisely because the lenders do not want to provide liquidity that Greece may be forced to default.  It looks like the creditors are pushing Greece deliberately into default.

The ECB is carrying a great responsibility.  By providing liquidity it could unlock the stranglehold the Greek government is kept in. Refusing to provide liquidity would make the ECB the single most important actor responsible for a Greek default and a possible Grexit.

Revolt of the debtors

The Greek debt crisis that erupted in 2010 is back, and again threatens the stability of the Eurozone. That crisis was the result of two factors. First, an unbridled spending drift of both the private and the public sectors in Greece during the boom years of 2000-2010, which led to unsustainable large levels of debt. Second, reckless lending to Greece by Northern Eurozone banks. At no time the Northern bankers asked themselves the question of whether the Greeks would repay the loans.

The European Unions chose to resolve the debt crisis by punishing the Greeks and by saving the Northern banks. A punitive austerity program was imposed on Greece, whose effects are now visible everywhere in this country. A decline in GDP of close to 25% since 2010, a rise in unemployment to a level we have not seen since the nineteen thirties, and impoverishment of large parts of the Greek population.

The banks went largely unpunished. True there was a debt restructuring of the Greek debt held by private investors. Some banks paid the price of excessive credit granted to Greece, but most banks escaped this fate by dumping their Greek claims onto the public sector. Those claims are now in the hands of national governments and the European Central Bank. And these want to have their money back whatever the consequences may be for the Greek people and the Greek political system.

The official narrative of this approach is that the intense austerity that was imposed on  the Greek population is inevitable and in the end will bear fruit.

Inevitable? Yes, of course, if the intention is to safeguard the interests of the creditors then there is indeed only one possibility: the Greeks have to pay the full price.

Will it pay off in the end? Yes, of course if austerity is maintained long enough it will succeed in creating surpluses and transfers of resources from Greece towards the rich North of the Eurozone.

This narrative, however, loses sight of the political upheavals triggered by the human misery that results form intense austerity. The millions of people who are pushed into misery by the creditors from the North of Europe are not passive subjects. They not only protest in the streets, something the creditors can easily live with. They also vote for those political parties that promise them that there is a better way to deal with the problem. And these are the parties that are out to break the established political and social order.

It is appalling to see that the European political elite has been living in a cocoon, failing to take into account the political and social implications of the intense austerity programs they imposed in countries like Greece (but also in other countries of the periphery). This political elite still has not learned the lessons. The first reaction of the German minister of finance after the announcement of new elections in Greece was that the discipline needed to be continued rigorously.

What is to be done? Much will depend on the election results in Greece. The far-left party, Syriza, seeks to weaken the intensity of the austerity programs and to negotiate a debt restructuring with the European authorities.

It is quite surprising to find out that these demands, in fact, are based on a correct analysis of the Greek problem. Despite the austerity, that has been extraordinarily intense, the Greek public debt has increased and now exceeds 170% of GDP. The burden of this debt is so high that future Greek governments will not be able to continue to service it.

Instead of denying this reality the EU finance ministers should start facing it. They should begin to think about how they can ease the debt burden of Greece. Denying this reality condemns Greece to many more years of misery and will encourage extremist political movements in the country even further.

The risk today is that the political leaders of the Eurozone refuse to relieve the Greek debt (and that of other countries of the periphery). In that case, a fundamental crisis in the Eurozone is inevitable. Even if Syriza does not make it at the coming election, extremist parties will gain the upper hand in future elections. This will be very disruptive for the Eurozone as a whole.

History teaches us that after a debt crisis a balance must be found between the interests of creditors and debtors. The unilateral approach that has been taken in the Eurozone in which the debtors have been forced to bear the full weight of the adjustment almost always leads to a revolt of these debtors. That is now underway in Greece. It can only be stopped if creditors dare to face this reality.

The dangerous ambitions of the European Central Bank

Last week the European Central Bank published the letter it sent on August 5, 2011 to the then Prime Minister of Spain, Mr Zapatero. That was at a time of intense crisis in the Eurozone. Many thought that the Eurozone would implode.

The ECB’s letter to the Spanish government is not the only one the ECB sent to Member States' governments. A similar letter was sent to the Italian Government. The letter is of great significance because it reflects the ambition of the central bank to determine macroeconomic policies in the Eurozone. This ambition should be checked, for two reasons.

First, the letter illustrates the intensity of  the micro-economic management the ECB intends to apply in crisis countries. The letter contains a detailed list of what according to the ECB needs to be done in the labor market. Thus, collective agreements should be abolished and should be organized at the level of the individual firms. In addition, these agreements should not contain indexation clauses, even when these are entered into freely. Two things stand out here. First, there is the detail of the measures that the ECB would like to impose. In doing so, it substitutes itself to national governments in the formulation of national economic policies.

Second, it is striking to find that these policy prescriptions are based on an economic theory for which there is actually no serious empirical evidence. On the contrary, there is a strong empirical research suggesting that the degree of decentralization of wage bargaining should not go too far. The consensus among economists is that wage bargaining at the level of individual companies harms the economy, because it can easily give rise to a wage-price spiral when an external shock such as an oil price increase occurs. Yet extreme decentralisation of wage bargaining is what the ECB wants to impose in member-countries of the Eurozone. The policy that the ECB seeks to impose is not based on evidence but on ideology.

The second reason why the ECB’s ambitions in setting the policy agenda in the Eurozone must be checked has to do with governance. The ECB is a public institution, which has been given a strong status of political independence. The latter implies that politicians should abstain from interfering in monetary policy. They should certainly not give instructions to the central bank on how to conduct monetary policy. The reverse, however, is equally true. The political independence of the ECB can only be safeguarded if that institution keeps itself aloof from the political process and abstains from giving instructions to governments about how economic policies should be conducted. The ECB sins against this principle. In doing so, she puts her own independence at stake.

The ECB has set itself the target of keeping inflation close to 2%. It is failing spectacularly in reaching that objective and as a result, creates a risk of deflation that today increases the debt burden of national governments. An institution that fails to achieve its own objectives cannot afford to impose its ideas on national governments, lest these governments will turn themselves against the ECB.

The instructions the ECB gives in its letter to the Spanish government lead to an even more fundamental governance problem. The ECB consists of civil servants who bear no political cost of the decisions they try to impose on national governments. The latter bear the full political costs of these decisions. They risk to be thrown out of office when they implement policies forced upon them by the ECB. The civil servants of the ECB go home unharmed. This is a governance structure that is unsustainable and that will be rejected. It is important that the ECB realises this and reduces its ambition to rule the politicians. Failure to do so will greatly harm the ECB.