The Magic of the Market
Why Greece Will Default
Martin Feldstein
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CAMBRIDGE – Greece will default on its national debt. That default will be due in large part to its membership in the European Monetary Union. If it were not part of the euro system, Greece might not have gotten into its current predicament and, even if it had gotten into its current predicament, it could have avoided the need to default.
Greece’s default on its national debt need not mean an explicit refusal to make principal and interest payments when they come due. More likely would be an IMF-organized restructuring of the existing debt, swapping new bonds with lower principal and interest for existing bonds. Or it could be a “soft default” in which Greece unilaterally services its existing debt with new debt rather than paying in cash. But, whatever form the default takes, the current owners of Greek debt will get less than the full amount that they are now owed.
The only way that Greece could avoid a default would be by cutting its future annual budget deficits to a level that foreign and domestic investors would be willing to finance on a voluntary basis. At a minimum, that would mean reducing the deficit to a level that stops the rise in the debt-to-GDP ratio.
To achieve that, the current deficit of 14% of GDP would have to fall to 5% of GDP or less. But to bring the debt-to-GDP ratio to the 60% level prescribed by the Maastricht Treaty would require reducing the annual budget deficit to just 3% of GDP – the goal that the eurozone’s finance ministers have said that Greece must achieve by 2012.
Reducing the budget deficit by 10% of GDP would mean an enormous cut in government spending or a dramatic rise in tax revenue – or, more likely, both. Quite apart from the political difficulty of achieving this would be the very serious adverse effect on aggregate domestic demand, and therefore on production and employment. Greece’s unemployment rate already is 10%, and its GDP is already expected to fall at an annual rate of more than 4%, pushing joblessness even higher.
Depressing economic activity further through higher taxes and reduced government spending would cause offsetting reductions in tax revenue and offsetting increases in transfer payments to the unemployed. So every planned euro of deficit reduction delivers less than a euro of actual deficit reduction. That means that planned tax increases and cuts in basic government spending would have to be even larger than 10% of GDP in order to achieve a 3%-of-GDP budget deficit.
There simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline: Greece’s default on its debt is inevitable.
Greece might have been able to avoid that outcome if it were not in the eurozone. If Greece still had its own currency, the authorities could devalue it while tightening fiscal policy. A devalued currency would increase exports and would cause Greek households and firms to substitute domestic products for imported goods. The increased demand for Greek goods and services would raise Greece’s GDP, increasing tax revenue and reducing transfer payments. In short, fiscal consolidation would be both easier and less painful if Greece had its own monetary policy.
Greece’s membership in the eurozone was also a principal cause of its current large budget deficit. Because Greece has not had its own currency for more than a decade, there has been no market signal to warn Greece that its debt was growing unacceptably large.
If Greece had remained outside the eurozone and retained the drachma, the large increased supply of Greek bonds would cause the drachma to decline and the interest rate on the bonds to rise. But, because Greek euro bonds were regarded as a close substitute for other countries’ euro bonds, the interest rate on Greek bonds did not rise as Greece increased its borrowing – until the market began to fear a possible default.
The substantial surge in the interest rate on Greek bonds relative to German bonds in the past few weeks shows that the market now regards such a default as increasingly likely. The combination of credits from the other eurozone countries and lending by the IMF may provide enough liquidity to stave off default for a while. In exchange for this liquidity support, Greece will be forced to accept painful fiscal tightening and falling GDP.
In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt. At that point, Greece will default.
Martin Feldstein, a professor of economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisors and President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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duglarri 12:12 29 Apr 10
I find one statement in this article stands out: <because Greek euro bonds were regarded as a close substitute for other countries’ euro bonds>
Isn't the implication of this statement that the consumers of bonds haven't the slightest idea what they're doing? That they bought these bonds utterly blind and are now going to get killed on them? That international bond investors, the ones whose demand sets the interest rates, are complete morons?
What does that say about the entire international interest rate system? Doesn't this pretty much conclusively establish that it's driven by people who have not the faintest clue what they're doing?
quahch 05:11 29 Apr 10
Few important points you must remember prof:
First, if you have read Milton Friedman, you should know that what matters is real exchange rate or the real price of money, not the nominal amount. Hence, you need to factor in the possible changes in the price levels in Greece when you argue for a separate currency for Greece. Under devaluation, the prices of exportables and importables will rise, and the gains from increased competitiveness could have been overwhelmed by rise in inflation which made the benefits from devaluation small if any.
Moreover, devaluations did not help Argentina or any other countries which had faced financial difficulties in the past. It only "chased" more funds away from the troubled countries. Devaluation will spur expectations for more future devaluations.
Second, for an open economy, whether in capital or currency accounts, floating exchange rates are by no means the tool to correct budget balances. Exchange rates are just nominal variables, while deficits are driven by real fundamentals and the behavior of governments.
Third, on the role of the yields on bond in signaling to the market the real fundamentals of the Greek government, remember that even in the US, the prices and yields of the assets did not convey correct information to the US public until only when the housing bubble burst.
So, do you imply that US should have different currencies? One separate currency for California perhaps? So that the run-up to the housing bubble could be better reflected?
Prof, I urge you to read McKinnon, Mundell, Friedman, Taylor, and even Krugman on this issue
Quah, Chee Heong
Carax 09:11 01 May 10
Let Greece default because it will be the least harmful of the options available.
Greece was never qualified to join the euro to begin with and once it joined abused its membership in the club with creative accounting. Bailing out Greece will move billions from hard-working, productive people to squanderers who cannot curb their consumption.
This is not totally Greece's fault. When the EU allowed them membership, despite the rules for bail-out packages, they encouraged them, encouraged irresponsibility, like other countries, Italy, Spain, etc. for easy access to loans, instead of only borrowing money based on actual savings. Loans from the ECB which produces money out of nothing. So it looks like Greece will be rewarded for its debt addiction and Italy and Spain and Portugal will follow suit.
Where is the money going to come from?
Eliminating Greece from euro membership will force them into an austerity program, get their house in order and send the signal to Spain, Italy and Portugal to do the same. You don't cure a drug addict by feeding injecting them with more drugs.
aussiereader4 09:41 02 May 10
'Reducing the budget deficit by 10% of GDP would mean an enormous cut in government spending or a dramatic rise in tax revenue – or, more likely, both. Quite apart from the political difficulty of achieving this would be the very serious adverse effect on aggregate domestic demand, and therefore on production and employment. Greece’s unemployment rate already is 10%, and its GDP is already expected to fall at an annual rate of more than 4%, pushing joblessness even higher'.
This is the reason the current plans makes no sense at all.
Quantitative easing is required for the whole 'Eurozone' with the money distributed on the basis of GDP. The figure will be 20% of GDP. The proceeds in the Northern European nations should go to the taxpayers. The Piigs should pay off debt with the money.
The result will be devaluation of the Euro with Greece getting 68 Billion and Germany about 600 Billion.
ckwrites 06:12 10 May 10
It is "somehow natural" to postulate a Greece's default, given where the country is now. However, one should not underestimate the resolve and ingenuity of the Greek people {albeit the mass protest widely reported}, and of the Eurozone leaders to prevent such a default. Notwithstanding Greece's dubious behaviour in managing its spending in the past decade and as a consequence creating for herself a mammoth debt, we should pray that the country learns its lesson, roll out the necessary austerity measures, and her people accept responsibilities to change. Many other countries in the world, especially those with huge external debts, must quickly learn the Greece lessons. They could be within a whisker to becoming another Greece.
quahch 03:19 28 Apr 10
Few important points you must remember prof:
First, if you have read Milton Friedman, you should know that what matters is real exchange rate or the real price of money, not the nominal amount. Hence, you need to factor in the possible changes in the price levels in Greece when you argue for a separate currency for Greece. Under devaluation, the prices of exportables and importables will rise, and the gains from increased competitiveness could have been overwhelmed by rise in inflation which made the benefits from devaluation small if any.Moreover, devaluations did not help Argentina or any other countries which had faced financial difficulties in the past. It only "chased" more funds away from the troubled countries. Devaluation will spur expectations for more future devaluations.
Second, for an open economy, whether in capital or currency accounts, floating exchange rates are by no means the tool to correct budget balances. Exchange rates are just nominal variables, while deficits are driven by real fundamentals and the behavior of governments.
Third, on the role of the yields on bond in signaling to the market the real fundamentals of the Greek government, remember that even in the US, the prices and yields of the assets did not convey correct information to the US public until only when the housing bubble burst.
So, do you imply that US should have different currencies? One separate currency for California perhaps? So that the run-up to the housing bubble could be better reflected?Prof, I urge you to read McKinnon, Mundell, Friedman, Taylor, and even Krugman on this issue.