Saturday, November 1, 2014
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The Debt Death Trap

NEW YORK – The Greek financial saga is the tip of an iceberg of problems of public-debt sustainability for many advanced economies, and not only the so-called PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Indeed, the OECD now estimates that public debt-to-GDP ratios in advanced economies will rise to an average of around 100% of GDP. The International Monetary Fund has recently put out similar estimates.

Within the PIIGS, the problems are not just excessive public deficits and debt ratios (in different degrees and measures in the five countries). They are also problems of external deficits, loss of competitiveness, and thus of anemic growth.

These are economies that, even a decade ago, were losing market share to China and Asia, owing to their labor-intensive and low value-added exports. After a decade that saw wages grow faster than productivity, unit labor costs (and the real exchange rate based on those costs) appreciated sharply. The ensuing loss of competitiveness manifested itself in large and growing current-account deficits and slowing growth. The final nail in the coffin was the appreciation of the euro between 2002 and 2008.

So, even if Greece and other PIIGS had the political resolve to reduce massively their large fiscal deficits – and that is a big if, given the political resistance to spending cuts and tax increases – fiscal contraction may, at least in the short run, make the current recession worse as higher taxes and lower spending reduce aggregate demand. If GDP falls, achieving a certain deficit and debt target (as a share of GDP) becomes impossible. This, indeed, was the debt death trap that engulfed Argentina between 1998 and 2001.

Restoring sustained growth requires real currency depreciation. There are only three ways that this can occur. One is deflation that reduces prices and wages by 20-30%. But deflation is associated with persistent recession (see Argentina again), and no country’s society and political system can accept years of recession and fiscal austerity to achieve real depreciation. Default and an exit from the euro would occur well before that.

The second path is to follow the German model of accelerating structural reforms and corporate restructuring to increase productivity growth while keeping wage growth moderate. But it took a decade for Germany to reduce its unit labor costs that way; if Greece or Spain were to start today, the short run costs of resource reallocation would be large, while the benefits in terms of higher growth would take too many years to achieve.

Finally, the euro could fall sharply in value. But the main beneficiary would be Germany. And, in order for the euro to fall far enough, the risk of default in Greece would need to be so large, and the contagion to sovereign spreads of PIIGS so severe that the widening of those spreads would cause a double-dip eurozone recession before currency depreciation could yield benefits.

Short of a miracle, Greece looks close to insolvency. At the onset of its crisis, Argentina’s budget deficit, public debt, and current-account deficit (as a share of GDP) were about 3%, 50% and 2%, respectively. Those ratios for Greece are far worse: 12.9%, 120% and 10%. So it will take a Herculean effort, luck, and support from the European Union and the IMF to reduce the probability of an eventual default and exit from the eurozone.

Greece is currently too interconnected to be allowed to collapse: since it has about $400 billion of public debt – three-quarters of which is held abroad, mostly by European financial institutions – a disorderly default would lead to massive losses and risk a systemic crisis. Moreover, the contagion to the sovereign spreads of the other PIIGS would be massive, tipping over several of these economies.

So, despite revulsion on the part of Germany and the European Central Bank at the idea of a “bailout,” Greece needs large official financial support this year at rates that are not unsustainable to prevent its current illiquidity from devolving immediately into insolvency. But official support will only kick the can down the road until next year. The magic trifecta of sustainable debt and deficit ratios, a real depreciation, and restoration of growth looks unlikely to be achievable even with official financial support.

All successful rescues of countries in financial distress – Mexico, Korea, Thailand, Brazil, Turkey – require two conditions: the country’s credible willingness to impose the fiscal austerity and structural reforms needed to restore sustainability and growth; and massive amounts of front-loaded official support to avoid a self-fulfilling rollover crisis of maturing public and/or private short-term debts. Reform without money on the table does not work, as nervous and trigger-happy investors would rather pull their money out if the country lacks the foreign-currency reserves needed to prevent the equivalent of a bank run on its short-term liabilities.

So, after a totally flawed plan that would have given money to Greece too late – only when the country risked a refinancing crisis – and at market rates that would make its debt unsustainable, the EU regained its senses and designed a new scheme that is closer to typical IMF conditionality: tranched support with some early front-loaded support and a semi-concessional interest rate.

Only time will tell if this plan will work: i.e. whether Greece will turn out to be illiquid but solvent, conditional on credible fiscal austerity and structural reforms and with the help of large amounts of financial support. But, as with Argentina, Russia, and Ecuador, Greece may also be insolvent if adjustment fails to restore debt sustainability and growth. For now, the official community has decided to stick with Plan A; if that fails, Plan B is default to reduce unsustainable debts and a Greek exit from the eurozone to allow depreciation and restoration of competitiveness and growth.

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