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How to End the Greek Tragedy

SANTIAGO – European leaders, faced with the reality of an insolvent Greece, are reportedly now considering a “Plan B” that would involve reducing the burden of its future debt payments. This is a welcome contrast to the options considered so far, all of which involved – under different guises – foisting more debt onto a country that has too much of it already.

Greek public debt today stands at nearly 160% of the country’s official GDP. Suppose Greece took 25 years to bring it down to the Maastricht ceiling of 60%. If the real interest rate on Greek debt were 4% (more or less what Greece is paying now for the emergency loans from the European Union) and annual GDP grew by 2% on average, the required primary fiscal surplus each year for the next quarter-century would be 5.7% of GDP. That is an unimaginably large burden, and it risks condemning Greece to permanent recession and social unrest.

A possible counterargument is that Greece has a large informal economy, so its actual GDP is larger than the official figure. As a result, the debt ratios commonly applied to Greece could be overstated. But informal output is of little use for debt service if it cannot be taxed. In any case, the scope for tax increases is severely limited in an economy that is shrinking quickly.

The conclusion is clear: Greece’s debt-service burden is too large, and it must be reduced. This can be accomplished in two ways: sharply cutting the interest rate paid by Greece, or reducing the face value of the debt.

Some analysts – most prominently Jeffrey Sachs – have argued that the best way forward is to cut the yield on Greek debt to that of German public debt. Germany currently pays a little over 3% nominal interest on 10-year debt, half of what Greece is being charged for emergency loans – and far less than Greece would pay if it attempted to raise money in private markets.

This approach has several advantages: by leaving the face value of the debt unaltered, EU officials could argue that restructuring Greece’s debt did not amount to a default, thereby limiting contagion. European banks holding Greek government debt could keep pretending that it is worth its full value. And the European Central Bank would have fewer excuses to refuse Greek bonds as collateral.

The question is whether the change in coupons – possibly coupled with an extension of maturities – would be enough to stabilize the Greek economy and restore growth. Even with German-level interest rates, Greece would have to run a primary surplus of at least 2% of GDP – still quite large, and far from today’s deficit. And, with the face value of the debt unchanged, the psychological drag on expectations and investment might linger.

The alternative is to cut the face value of Greece’s debt. European leaders seem to be moving in this direction. The required cut is large: eliminating half of Greece’s public debt obligation would leave it at nearly 80% of GDP, a ratio higher than Spain’s.

Talk of “haircuts” for private investors immediately triggers concerns about contagion. But markets are already assigning a high probability to a Greek default. The rating agencies have long placed Greek debt deep in junk territory, and are now giving Portuguese and Irish debt the same status. Rising spreads in Spain and Italy show that contagion is already occurring, even in the absence of an official decision to write down Greek debt.

The EU is pinning its hopes on one mechanism to reduce Greek debt: loans from the European Financial Stability Facility that would allow Greece to buy its own debt at a discount in the secondary market. But, while allowing the EFSF to finance buybacks is a step forward, a slew of theoretical and empirical research, generated by developing countries’ efforts to buy back their debt in the 1980’s and 1990’s, has shown that it is far from a cure-all. The main reason is simple: as debt is reduced, its price rises in the secondary market, sharply curtailing the benefits to the borrower.

So far, policymakers are talking only about exchanging old Greek bonds for cash (in buybacks) or new Greek bonds. It would be far preferable to exchange them for Eurobonds, backed by the full faith and credit of all eurozone countries.

Nor are European ministers, still struggling to catch up with reality, yet considering involuntary debt exchanges. But, if the past 18 months are any guide, they soon will be.