Greece's Third Bailout:
An Assessment of Circumstances and Policy Options
Following the vote of acceptance in the Greek parliament negotiations are ready to begin on the terms of a new agreement between Greece and its creditors. The negotiations will not be easy. Creditors have made it quite clear that they expect difficult reforms and austerity measures to be implemented. For Greece on the other hand this third program will allow the country to remain in the Eurozone and to pull back from the abyss.
The question, however, which taxes one's mind, is whether this new package will successfully end the crisis. For the next three years, assuming Greece implements the terms of the agreement, new crises should be avoidable. But what will be the shape of the Greek economy after this three year program? Can we reasonably hope for renewed growth next year? Will the debt burden be any more or less viable in three years?
The only true way to exit a debt crisis is either through the restructuring of the debt or through rapid economic growth. For the past several months the Greek government has tried to negotiate the restructuring option. These efforts are certain to continue and the IMF appears to be an ally in the effort. However, success will not be easy. The difficulty is that most of the debt is now owed to the official sector (i.e. other governments or supra-national institutions). It is difficult to negotiate haircuts with such creditors, because the issue becomes a political conflict rather than a commercial discussion. That could have been an option at the outset of the crisis, when the debt was owed to financial institutions (e.g. the PSI program negotiated with the IIF in 2012). That was the strategy adopted by Iceland. However, Greece followed the alternative strategy of asking for support from the EU and the IMF. So, now most of the national debt is owed to the official sector. Consequently, growing the economy is a more promising alternative.
The problem of course is for Greece to promote economic growth, while simultaneously implementing austerity. Many well known economists have pointed out that austerity traps economies in recession and continuing austerity leads to a downward spiral of economic depression. There is a possible solution to this trap, however. Two policy measures could be adopted to shift the recessionary trend in favor of growth. First, Greece has a very inefficient public sector. Moreover, the balance between the private and public sectors in Greece is badly skewed toward the public side of the scale. Adopting measures to promote efficiency within the public sector could free up resources for growth. Such an effort is long overdue. The issue is how to communicate the need for enhanced efficiency.
The idea that rising productivity enhances economic growth is very well established. In fact it is essentially a tautology. Unfortunately there is often resistance to productivity enhancements. But the fact is that rising productivity permits increases in gross production. The difficulty lies in the fact that clashes between class interests over the fair distribution of the economic pie often lead to confusion and a rejection of productivity gains. The result is we all remain poor, but continue to argue over the spoils. Within the Greek public sector productivity is very low. In recent years progress has been made in the introduction of technology platforms. But at the same time antiquated procedures have remained in place to temper productivity gains.
The second policy option is to liberalize the rules of the market in order to encourage private sector investment. It is notoriously difficult to do business in Greece. Once the current crisis recedes it is absolutely essential that policy measures be taken to encourage private sector activity. How else might the government act to improve the balance between the private and public sectors?
Unfortunately both of these policy options have been anathema to successive Greek governments over several decades. Whether this government or any Greek government can successfully break out of this cultural entrapment is an open question. Yet, if Greece fails to shift policy directions, the chances are very high that in three years’ time we will end up more or less exactly where we are today.
Two specific issues may help to explain the current predicament. The first issue relates to the Greek banking sector. The second example is the problem of the public pension funds.
Banking in Greece had been highly regulated for decades. However, in the ‘90s the banking sector was deregulated and several state owned banks were privatized. Over a period of roughly 15 years banking flourished. Credit to the private sector was more readily available. New technologies and products were introduced. And banks were quite profitable. Two trends caused these positive developments to derail. The first problem was that bank lending expanded far more rapidly than deposit growth. The funding gap was covered by borrowings from other European banks. That left Greek banks dependent upon foreign sources of funding. When the financial crisis began in 2008, Greek banks suddenly were unable to access liquidity. The second problem relates to the fact that Greek banks invested heavily in Greek government bonds. This was a profitable business segment prior to the introduction of the Euro. Unfortunately the legacy strategy was maintained and indeed exposure was increased after the introduction of the Euro. When the financial crisis mutated to a sovereign debt crisis, the banks were left holding seriously impaired assets. In 2012 with the imposition of the PSI haircut, Greek banks instantaneously went bankrupt.
A great deal can be said and argued over the wisdom of the PSI. In the case of the Greek banks the agreement to take a 50% haircut and accept a low interest and long dated rescheduling of the balance proved fatal. The EU and the IMF recognized the problem and put up 50B Euro to recapitalize the banks. Oddly they counted this capital as new loans to the Greek state. The reasons behind such a convoluted structure are purely political. Europe was not prepared to take ownership of the banks directly, since measures had not been agreed on implementing policies toward an EU-wide banking union. So, the Greek government took on additional debt of 50B to recapitalize its private banks, despite the fact that Greek debt was already at an unsustainable level.
Under the new agreement the EU is proposing an additional 25B to recapitalize the banks once again. After 3 more years of recession and a bank run that forced a bank holiday and capital controls, the Greek banks were left with a huge confidence deficit and tottering capital adequacy.. So, yes the banks need fresh capital. But why lend the necessary capital to an already overburdened Greek state. The columnist Hugo Dixon (Reuters / INYT) pointed out this fallacy in a recent opinion article. The EU should extend the capital directly and take direct control of the banks. Such a move would be a tremendous stimulus toward regenerating public confidence in the banks. Of course there are contrary views on this proposal, both in Greece and the EU. However, banking should no longer be a national game. (Just as countries are eventually going to be forced to abandon national airlines.) A full fledged banking union within the EU should begin now as a resolution to the current crisis in Greece.
The problem of pension funds in Greece has somewhat similar origins. Greece does not have particularly generous pensions. However, over the years policies had allowed on the one hand quite generous early retirement benefits. On the other hand the pension funds were poorly invested. Much of the available liquidity was invested in government bonds (just as the banks had done). The PSI hit the pension funds too therefore. Hence, pension funds with inadequate actuarial viability were immediately left in a severe crisis. (Clearly the planning of the PSI failed to consider the full fiscal impact.) So, what can be done?
Reducing pensions is of course one option. But that measure will certainly be recessionary. An alternative is to shift the structure of the pension system for future generations in a manner similar to what was done over twenty years ago in Latin America. Defined benefit plans are notoriously poorly invested when run by national governments. By converting pension schemes to defined contribution and individualized, investment portfolios the impact could be a boon to overall levels of investment. Ultimately Eurozone countries need to move toward pension fund union. Campaigning for such changes will be far more effective than begging for debt forgiveness.
Policy alternatives certainly do exist. They may be initially painful, but they are far more effective than praying for miracles. However, taking steps to realign policies requires creative thinking. My fear is that such thinking is culturally inconsistent with the political scene in Greece. The risk of enduring three more years of austerity only to find ourselves in the same stagnant, economic environment at the end of the program looms ominously.
Greece, July 16, 2015