The Hopeful Science
The Euro Zone’s Default Position
Simon Johnson and Peter Boone
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WASHINGTON, DC – Kazakhstan may be far removed from the euro zone, but its recent economic experiences are highly relevant to the euro’s current travails. As the euro zone struggles with debt crises and austerity in its weaker members, Kazakhstan is emerging from a massive banking-system collapse with a strong economic recovery.
For most of the last decade, Kazakhstan gorged on profligate lending, courtesy of global banks – just like much of southern Europe. The foreign borrowing of Kazakh banks amounted to around 50% of GDP, with many of these funds used for construction projects. As the money rolled in, wages rose, real-estate prices reached to near-Parisian levels, and people fooled themselves into thinking that Kazakhstan had become Asia’s latest tiger.
The party came to a crashing halt in 2009, when two sharp-elbowed global investment banks accelerated loan repayments – hoping to get their money back. The Kazakh government, which had been scrambling to support its overextended private banks with capital injections and nationalizations, gave up and decided to pull the plug. The banks defaulted on their loans, and creditors took large “haircuts” (reductions in principal value).
But – and here’s the point – with its debts written off, the banking system is now recapitalized and able to support economic growth. Despite a messy default, this fresh start has generated a remarkable turnaround.
The West European approach to dealing with crazed banks is quite different. Ireland, Europe’s (Celtic) tiger over the last decade, grew in part due to large credit inflows into its “Banking Real Estate Complex.” The Irish banking system’s external borrowing reached roughly 100% of GDP – two Kazakhstans. When the world economy dove in 2008-2009, Ireland’s party was also over.
But here’s where the stories diverge, at least so far. Instead of making the creditors of private banks take haircuts, the Irish government chose to transfer the entire debt burden onto taxpayers. The government is running budget deficits of 10% of GDP, despite having cut public-sector wages, and now plans further cuts to service failed banks’ debt.
Greece is now at a crossroads similar to that of Kazakhstan and Ireland: the government borrowed heavily for the last decade and squandered the money on a bloated (and unionized) public sector (rather than modern – and vacant – real estate), with government debt approaching 150% of GDP.
The arithmetic is simply horrible. If Greece is to start paying just the interest on its debt – rather than rolling it into new loans – by 2011 the government would need to run a primary budget surplus (i.e., excluding interest payments) of nearly 10% of GDP. This would require roughly another 14% of GDP in spending cuts and revenue measures, ranking it among the largest fiscal adjustments ever attempted.
Worse still, these large interest payments will mostly be going to Germany and France, thus further removing income from the Greek economy. If Greece is ever to repay some of this debt, it will need a drastic austerity program lasting decades. Such a program would cause Greek GDP to fall far more than Ireland’s sharp decline to date. Moreover, Greek public workers should expect massive pay cuts, which, in Greece’s poisonous political climate is a sure route to dangerous levels of civil strife and violence.
European leaders are wrong if they believe that Greece can achieve a solution through a resumption of normal market lending. Greece simply cannot afford to repay its debt at interest rates that reflect the inherent risk. The only means to refinance Greece’s debt at an affordable level would be to grant long-term, subsidized loans that ultimately would cover a large part of the liabilities coming due in the next 3-5 years. And, even on such generous terms, Greece would probably need a daunting 10%-of-GDP fiscal adjustment just to return to a more stable debt path.
The alternative for Greece is to manage its default in an orderly manner. Reckless lending to the Greek state was based on European creditors’ terrible decision-making. Default teaches creditors – and their governments – a lesson, just as it does the debtors: mistakes cost money, and your mistakes are your own.
With each passing day, it becomes more apparent that a restructuring of Greek debt is unavoidable. Some form of default will almost surely be forced upon Greece, and this may be the most preferable alternative. A default would be painful – but so would any other solution. And default with an “orderly” restructuring would instantly set Greece’s finances on a sustainable path.
After tough negotiations, the government and its creditors would probably eventually slash Greece’s debt in half. Greek banks would need to be recapitalized, but then they could make new loans again.
A default would also appropriately place part of the costs of Greece’s borrowing spree on creditors. The Germans and French would need to inject new capital into their banks (perhaps finally becoming open to tighter regulation to prevent this from happening again), and the whole world would become more wary about lending to profligate sovereigns.
Ultimately, by teaching creditors a necessary lesson, a default within the euro zone might actually turn out to be a key step toward creating a healthier European – and global – financial system.
Simon Johnson, a professor at MIT’s Sloan School of Management, a senior fellow at the Peterson Institute, and former chief economist of the IMF, is co-author of the forthcoming book 13 Bankers. Peter Boone, Chairman of Effective Intervention at the London School of Economics’ Center for Economic Performance, is a principal in Salute Capital Management Ltd.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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MGinProgress 12:09 18 Mar 10
Eventually if there is no other plans let Greece to orderly default on some bonds and German and French banks which invested into the country without "due diligence" will simply acknowledge their losses. It's like the sub-prime experience: if banks continue to invest in junks without further analysis, governments and other international organisations should not continue bail them out. I must say that in this respect German bankers are unfair: they invest in sub-primes or in bonds with high interest rates and lower rating, then when their bets turn sour they go back to governments and ask for help. Can we stop this?
http://mgiannini.blogspot.com/2010/03/euro-zone-stress-test-or-how-pigs-could.html
pdickson3 04:26 23 Mar 10
On the surface this seems logical and perhaps inevitable. However a few flaws to your argument come to mind. The first is that a default, while helping with the near-term fiscal situation, does not address the underlying problem of an uncompetitive position within the EU, namely that Greece will still face deflationary pressures until a real adjustment is made. In Argentina's case this was accomplished via a sharp devaluation of the currency -- something that is off the table for now for Greece. And while the default will help the fiscal outlook, it will not solve it. I suspect that a default will be met with even more contractionary pressures on the economy compounding the need for adjustment.
In fact, a default may require an equally sharp adjustment to the fiscal program given that Greece may find it more difficult to borrow in the market place post default. Again, something that Argentina managed to do but which seems out of reach for the Greeks.
You do not address the likely contagion a Greek default will have. And I do not only mean the contagion to the various banks that have Greek risk on their books. I also mean the contagion to other indebted sovereigns where the risk that they too will default will appear to be higher and which could lead minimally to higher borrowing costs or even to a sudden stop in capital flows. Not a nice prospect.
As an investor in both Kazakhstan and Argentina I can tell you that the differences between an orderly resolution of the Kazakh bank problems (urged and backed by the IMF) is a far cry from a sovereign default. It would be a better lesson for Ireland than for Greece.
The Greek Tragedy provides the clearest example of the greatest weakness of the Euro Zone: Lack of coordinated fiscal policies.
jnuetzel 11:03 25 Mar 10
As far as I remember, the greek problem is not lack of "due diligence" of investors, but continued organized crime / falsifying numbers and accounts by various greek governments, which were also not detected by the ECB.
Although I never bought greek debt, to blame an investor for his inability to smell the crime, despite ECB oversight, is very stretchy. How about resetting (public) wages and the extremely generous pensions just to the level of 2005, there was no EU inflation since that, adjust the pension age to the german reference 65/67 and slap just a 10 % one time tax on all greek property? That would bring both the debt and deficit to EU standards, Does that sound so bad ?
Nico 03:14 17 Mar 10
I think the case of Argentina is another good example of a country who was able to drastically reduce its debt load and get on the road to a massive economic recovery. The point is that in capitalist markets, the bankruptcy option must be made available to debtors. There were plans for this at the international level, as Stigltiz argued, but it was scuttled by Wall St. and other vested interests who did not want to concede that they had a major part in credit crises. They, instead, and with the explicit support of the US Treasury and IMF, forced debtors time and again to bail them out of their bad lending decisions. In order to stop the "Doom Cycle" creditors this time have to pay for their bad decisions. It takes two to tango, and debtors and innocent citizens shouldn't be the only one's paying for hubris.
www.perspectivos.blogspot.com