Giving Reform a Chance

If one is to believe the popular media, economists have finally found one issue to agree on: That Greece can only get out of its atrocious fiscal quagmire through debt restructuring.

Here, I’d like to argue for the opposite, even if that meant that, for once, I’d have to side with the politicians.

Let’s talk contagion first. In case you’ve missed it, repo markets for Spanish, Portuguese and Irish bonds are drying up, which raises flags of alarm for their respective banks and, indeed, any bank that is using them as collateral for funding. Debt restructuring by Greece would create a precedent that would be very hard for the markets to ignore when thinking about the rest of the PIGS.

Instead, avoiding a Greek restructuring (for now) gives a chance to the governments of these countries to take tougher measures to escape Greece’s fate. It also gives a chance to the European Commission and Council to prove that they have learned their lesson and can enforce fiscal discipline on a pre-emptive basis. Basically, it gives a chance to prevent a fresh round of financial instability in the eurozone, and to restore credibility in the institutions backing the entire European project.

The next line of reasoning has to do with “the point” of restructuring: Even with restructuring, the need for a drastic fiscal consolidation in Greece does not go away. Neither does the need for enforcing tax collection, downsizing an over-bloated public sector, eradicating corruption and improving competitiveness.

In addition, any haircut decision—and savings thereof—would have to be weighed against the new debt that would need to be issued to cover the losses of Greek financial institutions; and the much higher interest rates that Greece would be charged for its debt in the future (which would be higher the lower the recovery values and the higher the perceived probability of default).

Add to that the possibility of bank runs, collapse of confidence and the ensuing disruption in people’s daily routines, and you kill all incentives for reform by transforming an economic emergency into a national calamity.

Speaking of reform, it might have been easy to miss, amidst the catchy photos of rowdy anarchists parading in the middle of Athens, but.. there is actually a growing momentum for reform not only among the intellectual elite but also among the broader public—as demonstrated by the numerous self-critical op-eds and the more humble rhetoric of the Prime Minister himself.

On top of that, you have a government in its first year of a 4-year mandate and an utterly discredited opposition that leaves few political options for dissenters but the Communists, the Greens or… the Party of Greek Hunters! The IMF/EU package allows this momentum to continue by providing not only cheap(er) money but also an instrument for discipline and transparency in a country that has had none for years.

So much for the benefits. Now what are the risks of the IMF/EU approach?

Most people see the biggest risk being that Greece fails to deliver. I disagree. The biggest risk would actually be if Portugal or Spain failed to deliver more ambitious fiscal measures in the coming months. The point here being that the massive package for Greece is more about avoiding contagion to the rest of the eurozone than salvaging some 2% of EU GDP.

Then there is Greece itself. Those calling for upfront debt restructuring argue that the current package is fuelling moral hazard with the biggest “bailout” in history; and that, when the “inevitable” happens, the private sector will have to take a bigger haircut, since the official money disbursed would be senior to privately-held debt.

Not entirely. First, all the package does is cover Greece’s financing need for the next three years, including debt amortizations to the private sector—in full! So whatever haircut in the future will have to be considered together with the full repayments that debt holders will receive as a result of the package today.

When it comes to moral hazard, it is ludicrous to think at this point that the rescue package will encourage fiscal misbehavior in the rest of the eurozone or even by future Greek governments, given the painful measures that need to be adopted and the political humiliation of external monitoring.

However.. there is clearly a moral hazard issue when it comes to the holders of Greek debt, many of whom were happy to feed the Greeks with cheap money until they decided otherwise. Here, voluntary initiatives of the type allegedly discussed by German banks are a step in the right direction, even if too timid to counter the moral hazard concern.

But ultimately, the “rescue” of Greece (and of its debt holders) will have to be seen through the prism of avoiding contagion at a time too sensitive for the neighboring economies (and the IMF/EU) to bear.

Mind you, timing is critical: Provided Spain, Portugal and Ireland “behave”, a Greek debt restructuring would be much easier for the eurozone to bear a year or two from today, as the economy would be in better shape and the risk of contagion lower.

Greece may be too small (and too wayward) to bail but it’s become systemic by association. And while the rescue of an idiot who put his house on fire may be against one’s libertarian philosophy, keeping the fire from spreading elsewhere is (as we’ve painfully come to learn) sound policy.

Originally published at Models & Agents and reproduced here with the author’s permission. 

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