What Is Plan B for Greece?

Kenneth Rogoff, 

FEB 2, 2015 

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. 

TOKYO – Financial markets have greeted the election of Greece’s new far-left government in predictable fashion. But, though the Syriza party’s victory sent Greek equities and bonds plummeting, there is little sign of contagion to other distressed countries on the eurozone periphery. Spanish ten-year bonds, for example, are still trading at interest rates below US Treasuries. The question is how long this relative calm will prevail.

Greece’s fire-breathing new government, it is generally assumed, will have little choice but to stick to its predecessor’s program of structural reform, perhaps in return for a modest relaxation of fiscal austerity. Nonetheless, the political, social, and economic dimensions of Syriza’s victory are too significant to be ignored. Indeed, it is impossible to rule out completely a hard Greek exit from the euro (“Grexit”), much less capital controls that effectively make a euro inside Greece worth less elsewhere.

Some eurozone policymakers seem to be confident that a Greek exit from the euro, hard or soft, will no longer pose a threat to the other periphery countries. They might be right; then again, back in 2008, US policymakers thought that the collapse of one investment house, Bear Stearns, had prepared markets for the bankruptcy of another, Lehman Brothers. We know how that turned out.

True, there have been some important policy and institutional advances since early 2010, when the Greek crisis first began to unfold. The new banking union, however imperfect, and the European Central Bank’s vow to save the euro by doing “whatever it takes,” are essential to sustaining the monetary union. Another crucial innovation has been the development of the European Stability Mechanism, which, like the International Monetary Fund, has the capacity to execute vast financial bailouts, subject to conditionality.

And yet, even with these new institutional backstops, the global financial risks of Greece’s instability remain profound. It is not hard to imagine Greece’s brash new leaders underestimating Germany’s intransigence on debt relief or renegotiation of structural-reform packages. It is also not hard to imagine Eurocrats miscalculating political dynamics in Greece.

In any scenario, most of the burden of adjustment will fall on Greece. Any profligate country that is suddenly forced to live within its means has a huge adjustment to make, even if all of its past debts are forgiven. And Greece’s profligacy was epic. In the run-up to its debt crisis in 2010, the government’s primary budget deficit (the amount by which government expenditure on goods and services exceeds revenues, excluding interest payments on its debt) was equivalent to an astonishing 10% of national income.

Once the crisis erupted and Greece lost access to new private lending, the “troika” (the IMF, the ECB, and the European Commission) provided massively subsidized long-term financing. But even if Greece’s debt had been completely wiped out, going from a primary deficit of 10% of GDP to a balanced budget requires massive belt tightening – and, inevitably, recession. Germans have a point when they argue that complaints about “austerity” ought to be directed at Greece’s previous governments. These governments’ excesses lifted Greek consumption far above a sustainable level; a fall to earth was unavoidable.

Nonetheless, Europe needs to be much more generous in permanently writing down debt and, even more urgently, in reducing short-term repayment flows. The first is necessary to reduce long-term uncertainty; the second is essential to facilitate near-term growth.

Let’s face it: Greece’s bind today is hardly all of its own making. (Greece’s young people – who now often take a couple of extra years to complete college, because their teachers are so often on strike – certainly did not cause it.)

First and foremost, the eurozone countries’ decision to admit Greece to the single currency in 2002 was woefully irresponsible, with French advocacy deserving much of the blame. Back then, Greece conspicuously failed to meet a plethora of basic convergence criteria, owing to its massive debt and its relative economic and political backwardness.

Second, much of the financing for Greece’s debts came from German and French banks that earned huge profits by intermediating loans from their own countries and from Asia. They poured this money into a fragile state whose fiscal credibility ultimately rested on being bailed out by other euro members.

Third, Greece’s eurozone partners wield a massive stick that is typically absent in sovereign-debt negotiations. If Greece does not accept the conditions imposed on it to maintain its membership in the single currency, it risks being thrown out of the European Union altogether.

Even after two bailout packages, it is unrealistic to expect Greek taxpayers to start making large repayments anytime soon – not with unemployment at 25% (and above 50% for young people). Germany and other hawkish northern Europeans are right to insist that Greece adhere to its commitments on structural reform, so that economic convergence with the rest of the eurozone can occur one day. But they ought to be making even deeper concessions on debt repayments, where the overhang still creates considerable policy uncertainty for investors.

If concessions to Greece create a precedent that other countries might exploit, so be it. Sooner rather than later, other periphery countries will also need help. Greece, one hopes, will not be forced to leave the eurozone, though temporary options such as imposing capital controls may ultimately prove necessary to prevent a financial meltdown. The eurozone must continue to bend, if it is not to break.

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