Greece has done it, again. It has shaken the fundaments of the Eurozone, absorbed all energy and political capital and has come very close to breaking through the ‘no exit’ sign of the single currency. Although the Greek drama has some very specific twists that are not comparable to other crisis-stricken countries, its bloody six-month standoff leaves many open wounds in the fabric of the entire Eurozone.
All seemed to be going well at the beginning of 2015:
- The combined power of the ECB’s announcements of its bond-purchase programmes (outright monetary transactions and quantitative easing) eliminated breakup fears and reduced interest rates and sovereign spreads to levels last seen before the crisis started;
- The clean-up of the banking system was underway und progress on the establishment of the banking union was visible;
- The size of quantitative easing surprised markets on the upside and so did, eventually, economic growth of the currency area as a whole.
But by February 2015 all spotlights shifted back on Greece and the finance ministers and heads of state were back in full crisis mode – spending countless days and nights in seemingly fruitless negotiations.
Ultimately, the full clash was narrowly averted in July but no side can be happy with the result. The Greek saga has once again highlighted the incompleteness of the currency union and its vulnerability to renewed crisis.
This contribution argues that one of the key causes of the continuing crisis is the failure to adequately deal with debt. This argument is not specific to Greece – it applies to the entire Eurozone – even if Greece is in a whole different league when it comes to debt problems.
The failures are threefold:
- The failure of market discipline and an ineffective fiscal framework allowed too much accumulation of public and private debt in the first place;
- The failure of the Eurozone to address the debt overhang and legacy debt.
Euronze leaders relied instead almost exclusively on fiscal adjustment. This lead to low growth and it intensified the bank-sovereign loop.
- The lack of a credible sovereign insolvency regime complicates orderly debt restructuring and may contribute to renewed debt accumulation.
Failure 1 – accumulating too much debt
There can hardly be any disagreement on the diagnosis of too much debt accumulation over the course of the first eight years of the existence of the euro. By 2007 total debt (public plus private) had increased to dramatic levels (see Figure 1).
Much of the early increase was due to private debt accumulation in booming Ireland, Portugal and Spain, but it was largely socialized in the crisis. The failure to recognise the dangers of increasing private leverage was certainly not unique to Europe’s currency union. But the lack of monetary policy as an adjustment instrument at the national level made the consequences more severe than in other countries like the UK or the US.
Figure 1. Total debt of the Eurozone (% of GDP)
Figure 2. Public debt of selected Eurozone countries.
Source for all figures: Buttiglione et al. (2014)
In the early years of the currency union, markets did not exert any discipline on deficit-spending assuming – correctly – that the no-bail out clause would not bite when pressed. The average spread between the long-term borrowing rates of Greece, Ireland, Italy, Portugal, and Spain versus German long-term rates was only 25 basis points between 1999 and 2007 (see ECB data).
Public debt was quite stable until 2008 (see Figure 2).1 However, countries that had been allowed to enter the Eurozone despite failing to satisfy the Maastricht criteria on public debt (such as Italy or Greece) did not reduce debt levels and became vulnerable to the change in market sentiment as the crisis erupted. The failure to comply with the deficit rules was well-known even before the crisis. The fiscal framework clearly did not exert a sufficient disciplining effect, moreover, it was further weakened after France and Germany colluded to circumvent the rules in 2003.
The most prominent feature of Figure 2 is the rapid increase in public debt during the crisis due to a combination of increasing deficits and the takeover of private debt onto public balance sheets. By 2014 public debt levels in the Eurozone as a whole stood at 97% of GDP, almost 30 percentage points higher than at the onset of the crisis. Now, the Eurozone had an excess public debt problem.
Failure 2 – no common approach for dealing with excess sovereign debt
So far, there has been little appetite for a common approach to dealing with the legacy sovereign debt, in part due to the view that the accumulation of excess debt was the responsibility of every individual country, and that the resulting problems are largely confined to the country-level. However, this narrow view seems misguided. The dangers of high debt can threaten the entire monetary union through multiple adverse feedback loops and externalities (see Corsetti et al. 2015):
- First, high public debt exposes a country to risks of a self-fulfilling crisis.
If rising risk premia call into question fiscal solvency, banking health and economic activity is likewise stifled. This, in turn, exacerbates fiscal pressures on the government. Moreover, such crises tend to be highly contagious and to spill over other vulnerable countries.
- Second, a high debt service burden poses the risk of chronic low growth.
Uncertainty about fiscal adjustment may act like a prohibitive tax on new private investment and labour income. In turn, low growth increases the adjustment burden. Moreover, it has negative spill-overs on trading partners and complicates the conduct of the single monetary policy when it also causes large discrepancies in economic performance across member states.
- Third, a high public debt level imposes large externalities – through direct and indirect systemic effects – on the rest of the monetary union when any attempt is made to restructure debt.
Moreover, it creates a problem similar to the ‘too-big-to-fail’ conundrum of financial institutions. On the one hand, creditors have incentives to gamble for resurrection by financing even in cases of unsustainable debt dynamics, thus imposing an outsized adjustment burden. On the other hand, the debtor government may attempt to hold the rest of the currency union hostage by threatening to default and by resisting reforms.
The above list shows that high public debt should be a concern for the entire Eurozone. There should therefore be a common interest in undertaking fast and concerted actions to reduce Eurozone debt.
This has proven to be elusive. So far, the approach to dealing with excess debt has consisted of a combination of:
- Reinforcing fiscal rules, implementing fiscal contraction and structural reforms at the national level;
- Concessional financing from the European Stability Mechanism for programme countries; and
- Relying on the ECB to ensure favourable financing conditions for the rest through outright monetary transactions and quantitative easing.
The problem of relying on the ECB so heavily is that the Bank may be forced to act as lender of last resort to Eurozone governments – bringing the institution into the grey area between illiquidity and insolvency. Concerns about the risks to the ECB balance sheet may limit the Bank’s capacity for intervention as has already become evident in the case of quantitative easing, which is being implemented with minimal risk sharing.
The Bundesbank as well as the broader German establishment are increasingly critical of the expanding role of the central bank (see German Council of Economic Experts 2015: 25).
Despite this, there has been no appetite for a common and concerted fiscal approach to reduce public debt. The debt-redemption pact proposal of the German Council of Economic Experts (2011) was rejected because it involved the mutualisation of legacy debt (even the German Council itself is now rejecting the proposal).
Accepting the no-mutualisation red line, Corsetti et al (2005) have proposed an alternative approach for a rapid and concerted debt reduction. The proposal involves an agreement by all Eurozone countries to commit future revenues for the sake of retiring debt. They would bring forward current and future income streams and commit their net present value (NPV) to buy back the national debt now. Capitalising even small current and future income streams over a long horizon generates in net present value terms a large sum of money to buy back the debt. In addition, elements of solidarity and a debt equity swap could make the debt reduction deal viable and equitable.
The aim of the debt reduction deal is to eliminate legacy public debt, bringing debt in countries (expect Greece, which is a special case), below 95% and thus plausibly into the zone of solvency.
The second pillar of the proposal is a regime to deal with cases of unsustainable sovereign debt, which would help prevent countries from becoming too big to fail, again.
Failure 3 – no regime for dealing with sovereign insolvency
Although Greece is extreme in many ways, it has repeatedly highlighted the European failure to establish a regime for dealing with cases of unsustainable debt. After the no-bail out clause failed to prevent excess debt accumulation, the Eurozone had to find a quick fix when Greece lost market access in 2010. The solution was to rely on an IMF programme complemented by bilateral loans from European partners. Even though the IMF staff could not assure debt sustainability, the IMF Board decided to provide financing to Greece without debt restructuring.2
Over the following five years, Greek debt has been restructured several times. By now, the debt relief from the private sector and by the European official sector (prolonging maturities and reducing interest rates) has significantly reduced the net present value of Greek debt to below 100% of GDP (see Schumacher and Weder di Mauro 2015). Nevertheless, due to the gigantic economic cost of the prolonged standoff this year, the IMF now concludes that Greek debt is unsustainable over the medium run without further restructuring.
The heat map, the summary IMF Debt Sustainability Assessment (DSA) tool (see figure 4), now is entirely ‘red’ – meaning that there is a high risk of debt distress on all dimensions the IMF takes into account. Moreover, the Fund no longer is prepared to invoke the ‘systemic exemption’ that justified the programme in 2010 because of the diminished contagion effects of a Greek restructuring.
Figure 3. Greek public debt sustainability analysis risk assessment
Source: IMF (2015).
For the European creditors this raises the paradox that they are relying on the Fund to provide the framework (and the trigger) for debt restructuring, but are unwilling to grant the debt relief and would rather extend further financing.
This is the typical problem of time inconsistency (no bail out is optimal ex ante but not ex post) and the reason why the Eurozone needs to establish a workable regime to deal with sovereign insolvency. Reform proposals for debt restructuring regimes are abundant (see Bucheit et al. 2013) for an overview. The political will to implement them is not. In part this is due to principled concerns that it would weaken the credibility of the sovereign signature, in part this is explained by the fear of making the ongoing crisis worse.
The proposal by Corsetti et al. (2015) addresses the latter fear by combining a restructuring regime with the elimination of legacy debt (the debt reduction deal as sketched above). After legacy debt has been reduced under a common threshold (95% of GDP), ESM lending policies would be amended.
The ESM would condition access in cases of risk of debt distress (defined by the common threshold) on a one-time debt prolongation (reprofiling) or an immediate debt reduction. It is important to note that this debt restructuring regime fulfils the dual goals of, first, making sovereign debt crisis more manageable when they occur, and, second, discouraging renewed debt accumulation.
These three failures that inadequately dealt with high public debt are central causes of the continuing crisis. While other failures of the institutional framework have been recognised and partly dealt with, the failure to deal with the legacy excess debt may continue to haunt us for decades. Even worse, the failure to complement fiscal rules with an effective sovereign restructuring regime may be setting us up to repeat the same mistakes.
Bucheit L, A Gelpern, M Gulati, U Panizza, B Weder di Mauro and J Zettelmeyer (2013), “Revisiting Sovereign Bankruptcy”, Committee on the International Economic Policy and Reform, Brookings.
Buttiglione L, P Lane, L Reichlin and V Reihnhart (2014), “Deleveraging? What Deleveraging?”, Geneva Reports on the World Economy 16, ICMB and CEPR.
Corsetti, G C, L Feld, P Lane, L Reichlin, H Rey, D Vayanos and B Weder di Mauro (2015), “A New Start for the Eurozone: Dealing with Debt”, Report on Monitoring the Eurozone 1, CEPR.
German Council of Economic Experts (GCEE) (2011), “Euroarea in Crisis”, in Annual Report 2011/12, German Council of Economic Experts, Wiesbaden.
German Council of Economic Experts (GCEE) (2015), “Konsequenzen aus der Griechenland-Krise für einen stabilieren Euro-Raum”, Sondergutachten, July.
IMF (2014), “World Economic Outlook”, Washington, DC, October.
IMF (2015), “Greece: Preliminary Draft Debt Sustainability Analysis”, 26 June.
Schumacher, J and B Weder di Mauro (2015), “Debt Sustainability Puzzles: Implications for Greece”, VoxEU, 12 July.
1 Public debt of the Eurozone as a whole even decreased slightly from about 72% of GDP in 1999 to about 67% of GDP in 2007 (WEO 2014).
2 IMF staff had concluded that Greek debt was sustainable, but not with high probability. Under the exceptional access policy this would have prevented access to Fund resources without a debt restructuring. The quick fix for this breach in lending policies was to amend them (permanently) by introducing the systemic exemption. There were misgivings in the IMF board (see minutes of the board meeting of May 9, 2010 available at http://adlib.imf.org/digital_assets/wwwopac.ashx?command=getcontent&server=webdocs&value=EB/2010/EBM/353745.PDF), but the programme was approved nonetheless.