By Frank Thomas from the San Diego Free Press
Greece’s Solvency Problem
The Western world is moving out of a public debt-deflation crisis of the worst sort … and Greece is still in the middle of it as the worst example of a dire fiscal crisis in a weaker member country that can destabilize the entire euro zone.
Greece is simply de facto insolvent …as was Lehman Brothers in the recent Great Recession and the U.S. at the start of the Great Depression. The Troika (ECB [European Central Bank], IMF [International Monetary Fund], EU Commission) has been mistakenly treating the Greek bailout debt problem as a liquidity issue – optimistically hoping this in combination with tough reform measures would enable Greece to achieve debt sustainability and economically grow out of its debt problem. That’s failed … so far.
It’s not a liquidity issue. It’s an immediate and long term solvency crisis – an inability to generate adequate tax revenues and asset values (whether pledged or sold) to repay debts, especially those due in short term. Having just met a euro 750 million debt payment, Greece’s cash chest is empty. By June, two debt payments are due of euro 1.6 billion and euro 7.0 billion. Debt default is on the horizon.
Most of the euro 240 billion ‘bailout’ funds went to foreign creditor banks, not to fund Greek government operations. Even if Greece had ongoing access to ECB’s Emergency Liquidity Funds temporary funds, this wouldn’t solve underlying problem of excessive debt obligations and overall deficits after debt service, intensified by austerity measures aimed at improving the country’s competitiveness. During 2009-2014, wage, pension, and spending cuts shrunk GDP 26% . This and higher debt skyrocketed the debt/GDP ratio from 130% of GDP in 2009 to 175% in 2014. Greece’s tendency to be in budget deficit and debt troubles started long before the 2008-2013 great recession. This history and the great recession have pushed Greece into a disastrous “over-indebtedness, deflation and insolvency trap.”
Over-indebtedness and deflation are the two dominant drivers in recessions and depressions. Disturbances in debt and purchasing power trigger disturbances in most other economic variables. The spiral process develops along following lines: over-indebtedness leads to liquidation and stress selling of assets, leads to contraction of deposits and velocity of money circulation, leads to price deflation, leads to decline in net worth of businesses, leads to bankruptcies and lower business profits or losses, leads to a reduction in output and employment to cut losses.
When over-indebtedness does not reduce prices or deflation rises from other than debt causes, then the resulting cycle will be much softer or much less destructive. But, when the debt and deflation diseases occur together, as is happening in Greece, they act and react on each other. Then over-indebtedness leads to deflation and deflation leads to more debt owed – the more debtors pay, the more they owe. (See: “Debt-DeflationTheory of Great Depressions,” by Irving Fisher; “Falling Into a Liquidity Trap?” ECO-Societe Generale, Dec. 2013).
The more Greece cuts fiscal spending and hikes taxes, the more growth gets hit and deflation expands, the harder it becomes to meet ECB deficit and debt targets … leading to more debt required. The combination of extreme over-indebtedness and a policy of internal devaluation of assets, wages, pensions and other costs leads to deflation. Unchecked so far, this has brought Greece to insolvency where debts cannot be met by assets, even if sold.
When over time an economy with a rising high debt level has been depressed 26% by an internal devaluation, then the debt/GDP ratio will go UP, not DOWN … as is Greece’s story. It’s not just recession and deflation that push up debt. The existing huge public debt overhang acts as a drag on the economy. This is the circular debt and deflation economic stagnation Greece is stuck in. An economy caught in such a trap doesn’t easily return to a growth path and healthy debt/GDP ratio as Japan has demonstrated.
What Is Historical Origin of Greece’s Fiscal Troubles?
Greece has had a long history of fiscal trouble – an economy constantly burdened with excessive debt, budget deficits, bureaucracy, restrictive regulations, poor transparency, flaky statistics, and rampant corruption. Carmen Reinhart and Kenneth Rigoff in their book, “This Time is Different,” a history of financial crises, conclude Greece has spent half of the past two centuries in default.
Since WWII through 1998, Greece had hardly a balanced year without relying on heavy subsidies from abroad. Greece entered the euro zone in 2001 – using falsified debt and deficit numbers ignored by the banking establishment. During 2001-2007, the door opened for long term funds at low interest rates and under-pricing of default risk (supported by Germany’s credit worthiness). Thus, a sharp reduction in debt service costs gave Greece some fiscal space to reduce its debt burden. Instead, Greece went on a spending and debt splurge that placed its debt burden on an unsustainable path – where the primary budget deficit soared to over 10% of GDP in 2009 and the debt/GDP ratio jumped from 100% in 2001 to 130% in 2009.
Adding fuel to the fire, in 2002 investment banks like Goldman Sachs were offering complex, secret derivative products including cross currency swaps used to guarantee government revenues from bond issues in foreign denominations. These specially designed swaps provided a hedge against exchange rate oscillations using a fictional exchange rate, allowing a country to exchange its dollar (or Yen) loans into a greater number of euros. In Greece’s case, this hedge transaction created a credit (covert loan) of nearly $1 billion to the Greek government. Reporting of the credit in the balance sheet was not required by European accounting rules.
Since these swaps weren’t registered as debt, the Greek government and other EU governments were enticed to spend beyond their means. Greece exploited cross currency swaps presumably to help avoid the huge fines levied under the Maastricht Treaty for violating the 60% debt/GDP ratio limit and the 3% overall budget deficit limit.
The Greek people were neither aware of nor a party to the financial risks their government officials were exposing them to. Yet they, as taxpayers, are responsible for paying the price of a euro 240 billion European bailout debt. Social costs stemming from the government’s fiscal mismanagement have been excruciating – a 26% joblessness, massive homelessness, an educational system in shambles, a serious brain drain, a generational dead-end future for many.
Why Wasn’t Keynesian Pump-Priming Utilized?
One reasonable answer to this question comes from a Eurobank Research report: (See: Eurobank Research, “Is Deflation a Risk For Greece?”)
“Avoiding monetary and/or fiscal contraction during the recession and allowing automatic stabilizers to work, as suggested by Keynesian thinking, was not an option. Greece has purposefully implemented internal devaluation in order to reclaim price competitiveness losses against trade partners. Even if this was not the case, participation in a Monetary Union (i.e., loss of autonomy in the exercise of monetary policy) implies that the country would be unable to combat inflation via monetary means. In addition, given the huge size of public deficits and the explosive path public debt had embarked on, a fiscal expansion would only enlarge the fiscal crisis and the ensuing collapse of output. Loss of access in international capital markets meant a fiscal expansion was not feasible anyway. Instead, the country had to implement a draconian fiscal consolidation program which led to a contraction of the primary budget balance from a deficit of -10.5% in 2009 to a primary surplus of 2.1% in 2013.” (Editor’s note: 2.1% excludes huge 10.1% one-time recapitalization cost; primary budget surplus was 1.7%% in 2014 and a 2.9% primary surplus is expected in 2015).
An important point to stress here is that for the first time in more than a decade Greece is on a path of reporting a primary budget surplus (before debt payment) for the years 2013, 2014, and an expected surplus in 2015. After 6 years of a deep recession and 26% GDP decline, Greece appears to be emerging slowly out of the recession. Its economy grew 0.8% in 2014 and is forecast to grow more than 2.5% in 2015.
TABLE 1 shows Greece’s impressive fiscal adjustment i.e. significant improvement in its primary budget balance since 2009:
SOURCE: (“Should Other Eurozone Programme Countries Worry About A Reduced Greek Primary Surplus Target?” - Feb. 2015 Forecast of the European Commission)
The structural primary balance excludes both one-off measures (e.g., bank recapitalization costs) and impacts of the economic cycle. Greece’s 2009-2014 primary balance improvement of 11.9 percentage points from a -10.2% primary deficit in 2009 to a 1.7% primary surplus in 2014 is astonishing enough. A 2.9% primary surplus is expected in 2015. The structural primary balance improvement of 16.1 percentage points – is even more astonishing. It’s TWICE that of Ireland, Portugal and Spain. To stabilize Greece’s debt situation, the ECB and IMF believe the country must achieve a debt-stabilizing primary surplus target of 4.5% of GDP. This, however, does not negate fact Greece is insolvent and will still need constructive debt relief to reverse its debt-deflation spiral and spur economic growth.
Greece has two ills propelling insolvency: the Exceptional Scale of its Debt and the Weak Quality of its Assets supporting that debt. A state of insolvency occurs when an entity’s debts (liabilities) exceed its assets making it almost impossible to raise funds to meet financial obligations or to pay debts as they come due – regardless whether assets are sold or mortgaged. Greece’s Finance Minister himself has said, “Greece is bankrupt.” Mention of the ‘insolvency’ word makes creditors nervous and complicates ECB’s task as it’s apparently illegal to extend Emergency Liquidity Assistance (ELA) to an insolvent country. Greece is cash-strapped and can’t meet upcoming heavy debt repayments in July/August. So desperate is the situation, consideration is being given to tapping into the euro 1.5 billion reserve funds of local municipalities to stay afloat until end of May. Even temporary use of pension and social security funds is being reviewed.
And funding crunch pressures could get much worse. For example, a staggering outflow of over euro 20 billion of bank deposits has occurred since last November. Where will the funds come from to match this outflow? Another potential money pressure is that four big banks hold a huge euro 18 billion of capital in the form of Deferred Tax Assets and Deferred Tax Credits owed by the Greek state. If the banks request this money, it must be provided in cash, not government bonds. So over 50% of the Greek banking system – which is owned largely by the Greek state – is in the form of a cash IOU from the Greek state. This tight interconnectedness between the Greek state and its banks, operating under a “patronage” culture rather than a meritocratic system, has long magnified Greece’s gross mismanagement of its finances.(See: “ECB Asks: Are Greek Banks Solvent,” by Raoul Ruparel, Feb. 20, 2015)
Continuing an all-out austerity program to return Greece to a sustainable fiscal path needs to be rethought. Persistent deflationary pressure could hurt the country’s fragile debt sustainability now at 175% of GDP (vs. 130% in 2009). I believe internal deflation and enormous size of Greek debt make it impossible to grow out of that debt. Accepting more loans to meet debt service obligations worsens matters by further squeezing income and increasing debt. Still, despite 5 years of severe austerity, Greece’s broad economic picture is getting better, but life is much worse for most Greeks.
An excessive public debt curse constrains government actions by the need to service debt – which seriously compromises or crowds out critically vital investments in infrastructure, education, health care, child welfare, etc. The negative financial and social impact would have been much more disastrous without the bailout funds.
If a government is running primary budget deficits, it needs to borrow money to continue running. That has been the Greek government’s argument to its citizenry, namely, austerity is necessary to keep bailout funds coming to fund basic services like infrastructure, education, health care.
However, if a government is running primary budget surpluses as Greece now is, it’s much easier to get by without access to foreign debt markets. This depends on the timing and amounts of debt that must be paid to official creditors who are not about to accept a ‘haircut’ on the Greek debt owed them.
If Greece can raise recent trend of primary surpluses to 4.5% target of GDP, it will be able to finance its current level of consumption and investment, including government and private spending, without depending much on foreign capital inflows. That surplus will cover an interest cost of 4% of GDP, leave some fiscal space for economic growth incentives, for unforeseeable adverse cost events but not for high one-time costs which occur often in Greece. And it leaves little fiscal space to reduce debt principle and no space to meet large debt payments.
Where Are We Now?
Greece’s problem is insolvency, not a temporary liquidity shortfall. Funds are being lent to Greece to meet current debt service obligations on assumption this will bring Greece to renewed growth and income adequate to meet long-term debt obligations. Despite Greece’s weak economy and giant debt burden, 5 years of draconian austerity did produce a 1.7% primary budget surplus in 2014. BUT, the debt level still expanded to 175% of GDP from 130% in 2009.
This dramatizes how serious Greece’s insolvency problem is. Tough austerity measures and a huge euro 240 billion bailout injection of ‘liquidity’ funds – of which +85% went to creditor banks, not to fund Greek operations (except freeing up funds for basic social services) – can’t solve the over-indebtedness and deflation and insolvency trap. A crisis of distrust prevails, pitting debtor and creditor against each other. Many feel official lending by ECB and IMF is only worsening crisis and insuring a certain default and “haircut” for creditors.
ECB President Mario Draghi has laid down the financial ‘Maginot Line’ to Greece regarding bailout funds. In essence, his message to Greece is move fast on concessions and key reforms (e.g., inflated pensions, huge tax evasion, accounting irregularities) or you are on your own. In latter event, an ‘orderly default’ and ‘friendly exit’ from the euro currency zone, but not necessarily the EU, is the only recourse.
The ECB has cut off Greek access to the normal lending process where loan risk is divided among the 19 euro zone countries. For years, Greece has failed to meet a very important lending provision, namely, that the supporting collateral must be sound. In the ECB’s opinion, Greek bank collateral is not worth much. Accordingly, the ECB has stopped accepting Greek bonds as collateral. In essence, access to capital markets by the Greek government and Greek banks has been closed down.
In prior bailouts, the ECB waived the collateral provision. But, upon hearing of Premier Tsipras’ refusal to continue with key reforms, the ECB has withdrawn its waiver. Greece now only qualifies for Emergency Liquidity Assistance which the ECB is tightly limiting. ELA comes at a higher interest rate, and the Greek Central Bank assumes formal risk liability, not the euro zone countries. But, if something goes wrong, the euro zone is the ultimate backup.
According to Draghi, ELA support will be given providing Greek banks have adequate collateral and are solvent – two conditions that are not being met. A slowly developing bank run has brought the financial backup level of Greek banks below the peak-crisis level in 2012 – driving the interest rate on 3-year Greek securities to 30% range. In Draghi’s words, “Collateral is being destroyed.”
Greece’s interest payments are relatively low thanks to a low 2.2% average interest rate on its outstanding debt. If Greece had to borrow at the 8% market rate for its 10-year government bonds, its overall budget deficit would explode to over 15%. Despite the low 2.2% interest rate on public debt, total interest payments are still a substantial 4.0% of GDP due to Greece’s extravagant debt build-up.
Generally, a country’s national debt grows by the size of its overall budget deficit or surplus and strength of its economy. If Greece can consistently achieve a positive 2-4% primary budget surplus, its debt burden as a % of GDP will eventually decline so long as the GDP growth rate exceeds the average interest rate (now 2.2%) on government debt. (See: Martin Feldstein, Harvard Prof. of Economics – “The Greek Budget Myth,” Nov. 2013)
But, the Greek economy remains weak, not helped by severe austerity measures. Unless Greece can increase its rate of annual growth +2% and stabilize deflation, its overall budget deficit after debt payment will be high and the current 175% debt/GDP ratio will hardly change.
Where To Go From Here?
Greece’s acute insolvency is not being solved by spending and amassing debt far beyond its means and ability to grow itself out of the interest and principal debt payments. Result? Since the 2009 crisis, Greece has been forced to borrow more and more from the EU in an ‘ad hoc manner’ in emergency situations.
Daniel Gros and Thomas Mayer deftly address the problem of balancing of moral hazard by sharing EU support and risks vs. relying purely on financial markets to resolve an “excess debt-insolvency” crisis like Greece is experiencing.(See: “How To Deal With The Threat of A Sovereign Default in Europe,” March/April 2010; “Debt Reduction Without Default?” Feb. 2011). In Gros and Mayer’s opinion:
This ‘ad hoc manner’ (piecemeal liquidity) approach is unsatisfactory. The European Monetary system should be made robust enough to minimize the disruption caused by the failure of one member. The drafters of the Maastricht Treaty failed to appreciate that, in a context of fragile financial markets, the perceived (and real) danger of a financial meltdown makes a ‘pure’ no-bailout response unrealistic … The EU needs to design a scheme capable of dealing with the threat of sovereign default and capable of organizing an orderly default as a last resort … The strongest negotiating asset of a debtor is always that default cannot be contemplated because it would bring down the entire financial system.
For a Greek type of insolvency crisis, Daniel Gros and Thomas Mayer propose an innovative, fair market-based debt reduction option without a formal default. The concept shows promise for vastly mitigating disruption in financial markets caused by a foreign sovereign default. An orderly debt workout framework would help prevent a taxpayer bailout of a sovereign. Also, contagion effects would become very limited since market participants could estimate ex ante their maximum risk exposure by lending to another country. Some variation of the Gros-Mayer market-based debt reduction concept deserves reexamination by ECB authorities, if that has not already been done.
Greece is locked into a debt, internal deflationary economic stagnation that has all the ingredients of lasting as long as Japan’s 20 year economic stagnation! The ad hoc manner of accepting more loans to pay current debt service obligations only makes matters worse … as does an ongoing crushing austerity on the Greek people.
As to what to do now, I would give first priority to quickly and decisively restructuring Greece’s debt, including upcoming euro 1.6 billion and euro 7 billion payments.
The restructuring should provide real debt relief that allows Greece fiscal space to resume productive investment while also executing reforms selectively aimed at systemically poor tax collection, restrictive and regulatory labor practices raising the cost of doing business, inflated pension funds, absence of financial transparency and discipline, lack of confidence in statistical data, a governance and banking system functioning under an egregiously dishonest culture of ‘patronage’ rather than ‘meritocracy.’
The task is finding right balance between debt relief and limited austerity while not losing momentum with reforms, not increasing moral hazard or disrupting Greece’s real economy. The overall aim should be to improve Greece’s ‘economic model’ for responsible growth and access to capital markets.
Restructuring can take many forms, combinations: implementing a variation of the Gros-Mayer market-based debt reduction concept, swapping a portion of existing debt for bonds, linking interest payments to future economic growth as proposed by Greek Finance Minister Yanis Varoufakis, replacing Greek debt owned by the ECB with “perpetual bonds,” adopting a new Greek currency but keeping Greece in euro zone, rolling debt over, extending debt maturities or deferring debt payments.
If at the end of the negotiating process, parties cannot agree to an acceptable civil, humane, debt restructuring, debt relief and reforms in everyone’s best interest, then an orderly, friendly well-managed EXIT of Greece from the euro is the only option … leaving responsibility to Premier Tsipras’s government to resurrect an economy sunk in a sea of bureaucracy and debt.
An exit will hurt. Greece will eventually gain a more competitive currency, but this will not come cheaply without contagion impacts and some concrete costs. The current ECB euro 240 billion bailout averages euro +-600 per person for euro zone countries. How much this rises depends on the debt restructuring actions and reforms undertaken and how sound the exit process is risk-controlled. In this regard, the ECB has made a commitment to do “whatever is necessary to protect the euro.”
But, If Greece’s exit is judged a ‘least-worse’ scenario, what to do if the Portuguese, Spaniards, and Italians want a similar divorce? Greece out of the euro zone – given its geostrategic position at the crossroads between East and West – brings some indefinable risks.
Besides the economic issue, there’s a fundamental political issue … HOW IMPORTANT IS GREECE STRATEGICALLY TO EUROPE?
Frank Thomas May 18, 2015 The Netherlands