Greece: Past Critiques and the Path Forward

IMG_0248By Olivier Blanchard

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All eyes are on Greece, as the parties involved continue to strive for a lasting deal, spurring vigorous debate and some sharp criticisms, including of the IMF.

In this context, I thought some reflections on the main critiques could help clarify some key points of contention as well as shine a light on a possible way forward.

The main critiques, as I see them, fall under the following four categories:

  • The 2010 program only served to raise debt and demanded excessive fiscal adjustment.
  • The financing to Greece was used to repay foreign banks.
  • Growth-killing structural reforms, together with fiscal austerity, have led to an economic depression.
  • Creditors have learned nothing and keep repeating the same mistakes.

Critique 1: The 2010 program only served to raise debt and demanded excessive fiscal adjustment.

  • Even before the 2010 program, debt in Greece was 300 billion euros, or 130% of GDP.  The deficit was 36 billion euros, or 15½ % of GDP.  Debt was increasing at 12% a year, and this was clearly unsustainable.
  • Had Greece been left on its own, it would have been simply unable to borrow. Given gross financing needs of 20–25 % of GDP, it would have had to cut its budget deficit by that amount. Even if it had fully defaulted on its debt, given a primary deficit of over 10% of GDP, it would have had to cut its budget deficit by 10% of GDP from one day to the next.  These would have led to much larger adjustments and a much higher social cost than under the programs, which allowed Greece to take over 5 years to achieve a primary balance.
  • Even if existing debt had been entirely eliminated, the primary deficit, which was very large at the start of the program, would have had to be reduced. Fiscal austerity was not a choice, but a necessity. There simply wasn’t an alternative to cutting spending and raising taxes. The deficit reduction was large because the initial deficit was large. “Less fiscal austerity,” i.e., slower fiscal adjustment, would have required even more financing cum debt restructuring, and there was a political limit to what official creditors could ask their own citizens to contribute.

Critique 2: The financing given to Greece was used to repay foreign banks

  • Debt restructuring was delayed by two years. There were reasons for it, namely concerns about contagion risk (Lehman was fresh in memory), and the lack of firewalls to deal with contagion. Whether these reasons were good enough can be argued one way or the other.  In real time, the risks were perceived to be too high to proceed with restructuring.
  • Partly as a result of this delay, an important fraction of the funds in the first program were used to pay short term creditors, and to replace private debt by official debt. The bail-out did not however only benefit foreign banks, but also Greek depositors and households, as one-third of the debt was held by Greek banks and other Greek financial institutions.
  • Moreover, private creditors were not off the hook, and, in 2012, debt was substantially reduced: The 2012 private sector involvement (PSI) operation led to a haircut of more than 50% on about €200 billion of privately held debt, so leading to a decrease in debt of over €100 billion (to be concrete, a reduction of debt of 10,000 euros per Greek citizen).
  • And the shift from private to official creditors came with much better terms, namely below market rates and long maturities. Look at it this way: Cash interest payments on Greek debt last year amounted to 6 billion euros (3.2% of GDP), compared to 12 billion euros in 2009. Or put yet another way, interest payments by Greece were lower, as a proportion of GDP, than interest payments by Portugal, Ireland, or Italy.

Critique 3: Growth-killing structural reforms, together with fiscal austerity, have led to an economic depression

  • Given the dismal productivity growth record of Greece before the program, a number of structural reforms were seen as necessary, ranging from a reform of the tax administration, to reduced barriers to entry in many professions, to reforms of pensions, to reforms of collective bargaining, to reforms of the judicial system, etc.
  • Many of these reforms were either not implemented, or not implemented on a sufficient scale. Efforts to improve tax collection and the payment culture failed completely.  There was fierce resistance to open closed sectors and professions.  Only 5 of 12 planned IMF reviews under the current program were completed, and only one has been completed since mid-2013, because of the failure to implement reforms.
  • The decrease in output was indeed much larger than had been forecast. Multipliers were larger than initially assumed.  But fiscal consolidation explains only a fraction of the output decline.  Output above potential to start, political crises, inconsistent policies, insufficient reforms, Grexit fears, low business confidence, weak banks, all contributed to the outcome.

Critique 4: Creditors have learned nothing and keep repeating the same mistakes

  • The election of a government in 2015 openly opposed to the program further decreased ownership and required revisiting the existing program, both in terms of policies and in terms of financing.
  • A more limited set of structural reforms, or/and a slower fiscal adjustment implies, arithmetically, larger financing needs, and, by implication, more need for debt relief. To take an extreme case, if the European creditors were willing to simply forget all existing debt and extend further financing, there would be little need for more adjustment.  But, clearly, there were and are political limits to what they can ask their own citizens to contribute.
  • Thus, a realistic solution had to involve some adjustment, some financing, and some debt relief — a balanced approach. The role of the IMF in the negotiations was to ask for specific credible adjustments in policies, and make explicit the financing and debt relief implications.
  • We believed that a small primary surplus, increasing over time, was absolutely necessary to maintain debt sustainability. Having examined the budget closely, we did not see how this could be achieved without VAT reform to broaden the tax base, and pension reform to put the pension system on a sustainable footing.  On these, our views coincided fully with those of our European partners.
  • Until the referendum and its potential implications for growth, we believed that, under these assumptions about the primary surplus, debt sustainability could be achieved through the rescheduling of existing debt, and long maturities for new debt. This was reflected in the preliminary debt sustainability analysis (DSA) we put out before the referendum. Our assessment was seen as too pessimistic by our European partners to whom we had communicated our views about the need for debt relief long before publishing the debt sustainability analysis. We believe that current developments may well imply the need for even more financing, not least in support of the banks, and for even more debt relief than in our DSA.

A Path Forward 

  1. Given the results of the referendum, and the mandate given to the Greek government, we believe that there may still be room for an agreement. It should be based on a set of policies close to those discussed before the referendum, amended to take into account that the government is now requesting a 3-year program, and a more explicit recognition of the need for more financing and more debt relief.
  1. Fundamentally, the Euro area faces a political choice: lower reforms and fiscal targets for Greece means a higher cost for the creditor countries. The role of the Fund in this context is not to recommend a particular decision, but to indicate the tradeoff between less fiscal adjustment and fewer structural reforms on the one hand, and the need for more financing and debt relief on the other.
  1. The room for agreement is extremely narrow, and time is of the essence. There should be no doubt that exit from the Euro would be extremely costly for Greece and its creditors. The introduction of a new currency, and of redenomination of contracts, raises extremely complex legal and technical issues, and is likely to be associated with a further large decline in output.  It may take a long time for the depreciation of the new currency to lead to a substantial turnaround.

In sum, we still believe there is a path forward. The Fund is committed to helping Greece through this period of economic turmoil. Given Greece’s failure to make a repayment due to the IMF on June 30, the Fund would be unable to provide any financing until the arrears are cleared. However, we have offered to provide technical assistance, where requested, and we remain fully engaged.

8 Responses

  1. Macron said if Grexit materialises then the euro currency will last for about 10 years. In this scenario, an expensive German Mark and a cheap Spanish Peseta will correct the macro imbalances.

  2. There is much to agree in Olivier Blanchard’s rebuttal of the main critiques of the situation in Greece, but not with the statement that “fiscal consolidation explains only a fraction of the output decline”. A brief review of the facts follows. To begin with it is incontestable that Greece needed to improve its 2009 primary budget balance by some 30 billion to assure debt sustainability by 2013. The IMF’s standby arrangement (SBA) called for some 32 billion Euros of fiscal adjustment over this period, including the 16 billion Euros of measures announced in Greece’s stability program with the EU in early 2010. Hence, given the projections for exports (+13b) and for private investment (-3b), the projected fall in GDP (-3b) over this period is entirely attributable to the fiscal consolidation. Since only a small part of the programmed fiscal consolidation is needed to cover the limited GDP induced revenue fall, the fiscal adjustment is sufficient to assure the desired budget balance change.

    However, actual outcomes were quite different. By 2013 GDP had fallen massively (-55b); as did private investment (-16b) although with some offset from exports (+10b). The fall in private consumption is steep (-34b), but much of this is the result of the GDP fall. Non fiscal factors are now more significant but still cannot explain the bulk of the GDP fall. This is attributable to the much greater than programmed fiscal adjustment (48b instead of 32b) introduced as a result of slippages from annual budget balance targets. The GDP fall is so steep that despite the much bigger fiscal adjustment, primary budget balance targets could not be fully met. Nearly one-half of the fiscal adjustment over the period 2010-2013 was needed just to cover the GDP induced fall in revenue (22b based on a revenue ratio of 40 per cent).

    Viewing Greece from the perspective of the budget balance target, which creditors emphasise, there is under-performance. Viewing in terms of fiscal adjustments implemented and their adverse aggregate demand effects of concern to residents, there is massive over-performance. Absent non fiscal factors, a fiscal adjustment of 30 billion improves the budget balance by only 18 billion, owing to the revenue loss from a 30 billion decline in GDP (applying the updated IMF multiplier of 1 and revenue ratio of 40 percent). To secure the target improvement some 51 billion of fiscal adjustment is required, with GDP falling by the same amount. Revenue now falls over 20 billion but there is still enough fiscal adjustment for the target. Instead of a multiplier of 1, overriding automatic stabilizers through rigid budget balance targeting has raised the effective multiplier to 1.7. Too rigid an emphasis on budget balance targets can thus further destabilize GDP.

    The behaviour of non fiscal factors poses a dilemma. If they recuperate the debt sustainable budget balance would be attained with the initially projected fiscal adjustment; only temporary financing assistance is needed, with any added cost met through a bit more fiscal adjustment. However, if non fiscal factors are stagnant, securing the debt sustainable budget balance will require much more adjustment. Avoiding an ensuing extreme deflationary impact requires that the debt sustainable budget balance be lowered, which will only be possible with debt relief. In the former case the solution is to target the fiscal adjustment itself, while in the latter case, the solution is to provide debt relief. In neither case does the solution call for stringent budget balance targeting, which can render a potentially hopeful case into a disaster. Yet this is the approach that is now to be even more rigidly enshrined in the envisaged third bailout for Greece.

  3. Perfectly logical and sensible. Why cannot the Greeks understand it? What is missing is the overall macroeconomic environment in which Greece and others had to make their adjustments. It was and remains much too weak, and the creditors (especially Germany and the Netherlands) are responsible for that, not for not being willing to lend more to Greece.

  4. Mr. Blanchard,

    thank you for clearing the fog on this issue. Your blog entry should be mandatory reading for all participants in the discussion.

    Having said that I would like to add that from an outsider’s point of view, there seem to be a few disturbing aspects left:

    – Decisions affecting macro economics need to be based on data, but how valid and reliable is this data really?

    – Sustainable economic growth is the only way out of this mess, if Greece is to be kept in the Euro zone. As we are all dead in the long run😉, we need to ask: Where is the short- to mid-term growth potential in Greece’s real economy? Introduce structural reforms and then hope for the best, is that the strategy?

    – It is the inner logic of financial markets to try and identify profit potential in any situation. Aggressive investors have shown that they are able to destabilize currencies and countries. There seems to be a fundamental clash of interests between nations and the global financial market, which doubtless has played a role in the downturn of Greece. Are there any adequate solutions on the table that have a realistic chance of being implemented?

    Thanks again for your helpful and concise synopsis of the Greek crisis and its background.

    Kind regards,

    Christian Matschke

  5. There is a need to reflect deeper on the structural reforms included in the second aid program. Such a program should be feasible, effective and evaluable. Beside a discussion on the content of each reform that would go beyond this contribution, it appears that the extensiveness and complexity of the second aid program alone were sufficient to cause its failure and that it would not meet above standards. Looking at the fourth review of the program by the European Commission, not less than 21 separate headings were necessary to cover the areas of the program, including privatisations, fiscal policy, revenue administration, PFM, anti-corruption strategy, public administration reform, healthcare, education, pension, Research/development/innovation (!), financial system, labour market, social safety net, business environment, retail sector, regulated professions, judicial system, energy, transport, electronic communication, rural development, a true “catalog à la Prevert”. Lessons learnt from decades of reforms seem to have been completely forgotten. The reasons why such a “everything needs to be addressed “ -program cannot fly, are well known. First, if you open a broad front of reforms attacking several “rents”, you create conditions for a broad, political and social coalition against the reform process (as it happened). Sequencing matters. Second, adopting and implementing effectively reforms require scarce, not available administrative capacities. Third, multiplying the number of reforms requested, increase accordingly the risk of inconsistencies. Fourth, requesting changes everywhere, make the reform process unreadable and the identification of necessary correctives impossible. So my plea to the IMF for the third program: work with the European Commission to streamline the program and make it focused on what is relevant for a rapid growth recovery: not everything matters equally. In many and substantial aspects, the Greek case is certainly not the Islandic one. Nevertheless, taking as far as possible account of the principles that according to P. Thomsen conditioned the success of the Islandic program (his blog, 2011) would substantially enhance the third aid program compared to the second.

  6. Greece clearly needs debt relief of some sort but does not have to exit the euro to benefit from the effects of a devaluation. All deposits can be devalued relative to the euro monetary base, say 25% (level currently empirically observable), and all existing contracts would remain in euro, including current bank assets thereby improving their capital base. This is equivalent to flat tax on all citizens. The new exchange rate between inside money and the euro monetary base of 1.25 would be fixed and could be crawled back to parity over a 5 year period in a discretionary manner as structural reforms are implemented and the economy recovers. This recovery is likely because prices in the new complementary currency (inside money) would increase and the relative price of Greek goods and assets in terms of euros will decline, especially if this proposed solution is accompanied by a gradual fiscal adjustment. Fiscal adjustment will be aided by higher revenues in inside money terms and new contracts (government and private) payable in inside money. The ECB will continue to provide euro liquidity to solvent banks that can also continue to provide loans in either euros and in the new complementary currency and banks will be monitored in terms of currency liquidity mismatches and euro related credit risk. This proposal is detailed in a 2011 Economic Monitor Blog entitled “Greece can Devalue and Stay in the Euro”. Abdourahmane Sarr (former IMF).

  7. The IMF has been the one objective, fact-based analyst in the on-going Greek debate. Greek’s creditors must now embrace the IMF analysis, share the full cost of debt forgiveness and debt postponement and stop the torture of the Greek people.

  8. Mr Blanchard,
    Your response on the debt issue omits 3 key facts that made the burden sharing between the debtor (Greece) and the creditors (Europe) one of the most unfair in history: First, that by the time the haircut was imposed, the bulk of the debt was held predominantly by greek banks and pension funds, who bore huge losses and had to be recapitalized….. with more debt of the government from the troika! Second, by the time of the haircut, most foreign institutional holders of greek government bonds had gotten out (at an average price that was much higher than the restructuring price)…. Thanks to the loans granted to the government! The main holders were hedge funds who made huge profits subsequently. Third, even for the foreign banks that bore some capital losses as they exited, GGBs were a tiny portion of their portfolio compared to their holdings of Italian, Spanish, French etc bonds. The huge positive spillovers of Greece’s rescue on those bonds helped their balance sheet tremendously, making the losses on the GGBs a footnote by comparison.
    All of this happened at the IMF’s watch, at a time when Greece was supposed to be the IMF’s client–not Greece’s European creditors–under the IMF program with Greece. It’s high time the IMF played a far more constructive role in pushing for a fair burden sharing in the greek case.
    Sincerely, from a former IMF colleague.

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