Adjust and Reschedule or Delay and Default

Unless Greece reschedules its massive debt, it is unlikely to be able to roll over the approximately €30 billion maturing annually for the next few years. But if Greece reschedules its debt in the absence of a credible fiscal-adjustment program, financial markets would view the delay as merely a prelude to eventual default, which would drive the risk premium on Greek debt even higher.

BRUSSELS – As Greece activates its €45 billion rescue package with the International Monetary Fund and the European Union, it is becoming clear that a new, far more comprehensive approach is needed. Two problems need to be addressed: the credibility of Greece’s fiscal stabilization program, and how to cover the country’s medium-term financing gap.

The magnitude of the fiscal adjustment effort being demanded of Greece is now well known. The deficit has to be reduced by at least 10 percentage points of GDP (from around 13% of GDP to less than 3% of GDP). The key problem, which has not been addressed so far, is that a fiscal adjustment on this scale requires the government to take two steps that can be implemented only with wide social approval: a cut in wages and a cut in social expenditure. Both steps are now as unpopular in Greece as they are unavoidable.

The country’s competitiveness problems are also well known. Unit labor costs have increased by 10-20% more than in Germany. Assuming that Greece wishes to stay within the eurozone, an “internal devaluation,” i.e., a significant cut in nominal wages, is inevitable.