The near-run on the Greek public debt is wholly unjustified. The Greek government has no incentive to default, and no need to do so as long as financial markets do not panic. On the other hand, governments have indulged in blatant fiscal indiscipline for more than three decades. The renewed financial market pressure should be taken as a signal that the party is over. It is time for Greece to adopt two simultaneous measures:
- immediate deep spending cuts;
- reform of its budgetary process to credibly enforce discipline.
The credit downgrades by discredited credit-rating agencies
Credit-rating agencies, which everyone recognises as far-sighted, have downgraded the Greek public debt and announced that Spanish debt could well follow the same track. This came in the midst of market excitement and speculation by pundits that Greece would soon have to default, leave the euro area, or both.
These are the same markets that offered the world the high-tech bubble of the 1990s and the housing price bubble of the 2000s, and the same pundits who announced that the euro would never come to exist and, when it did, that it would soon break up. With such a track record, one wonders why reasonable people pay any attention to rating agencies, financial market panics, and pronouncements by devalued pundits.
A tight fiscal situation
True, the Greek government’s fiscal situation is uncomfortable. Its debt is expected to exceed 110% of GDP next year, but it stood at 118% in 1999, and Japan’s debt will soon reach 200% while the US hits 100%. True, the track record of previous Greek governments is pretty bad. The last time the budget was in balance was in 1972 – under the infamous colonels – and since then deficits have averaged 6% of GDP. True again, there seems to be a strange pattern in Greece – each newly elected government discovers that the previous one had concealed the extent of its deficits.
Greece is a country that has lost all sense of fiscal discipline and accounting honesty. But rating agencies are not supposed to pass judgment on discipline or honesty. Their only task is to determine the probability that a debtor will not meet its obligation. The question, therefore, is whether there is a chance that the Greek government, or a state-owned agency, will default, partially or completely.
Greece is not Argentina; it is most unlikely that its government will happily call off its debt obligations. A default will only occur if the authorities find it impossible to refinance maturing debt or to finance new debt. This is a decision that is in the hands of the financial markets. The current panicky mood makes it possible, especially if it is fuelled by rating downgrades and associated interest rate charges. Even if markets were to turn their backs to Greece, that does not mean an automatic default. If this occurred, Greece would, most likely, call up the IMF and promptly get some support to keep the debt afloat.
Short-run and long-run debt
It could be that credit agencies and markets are simply looking far into the future. The debt is currently large, but a continuation of budget deficits will eventually bring it to something that would look like infinity.
Given the past trend, this cannot be ruled out, so it could be wise not to lend now in order to avoid being caught by a default (much) later on. One could argue that the answer is to continue lending but only via short-maturity instruments that require continuous refinancing. In this case, an accident could happen any time, so the long-run threat is brought forward from the far future. Once again, the immediate trigger of a default would not be the Greek authorities’ decision to renege on its obligations but market edginess. This would not be an isolated event, of course. Self-fulfilling crises are too familiar to be ignored; this is the really worrying thing that is building up. It is a real threat.
What to do about it?
Could the EU prevent the looming disaster? Last February, Jean-Claude Juncker and Peer Steinbrück, then Germany’s Finance Minister, stated publicly that euro-area member governments would come to Greece’s rescue if the situation were to become serious (Buergin and Elfes 2009). My reading of the European Treaty is that it is impossible. Article 101 excludes financing by the ECB. Article 103 (1) states:
“a Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.”
It would also create a serious moral hazard problem, as I argued in a previous Vox column (Wyplosz 2009). The message to the new Greek government is and should be clear – the party is over.
Spending cuts are the acid test
Self-fulfilling crises only occur when vulnerabilities exist, and Greece’s sorry record of fiscal indiscipline constitutes a major vulnerability. As always, it would have been far better to address the problem in good times, but this is not an option anymore. Straightening the deficit in the midst of a recession is highly undesirable, but experience shows that painful reforms are more likely in bad times than in good times. The government must start acting now, just like the Irish government is doing.
Greece is a small open economy; its economic conditions strongly depend on the situation in its partner countries. The prospect that the EU has turned the corner is a powerful incentive for the Greek authorities to act now. Unfortunately, the early signals from the government are that the response will be more of the same as before – pledges to crack on tax evasion and spending inefficiencies. This will convince no one. The acid test is serious cuts in public spending. It will be politically painful, but cutting addiction is always painful.
Not everything must be done at once: A debt sustainability rule
The size of the effort – the deficit was more than 3% of GDP before the crisis – implies that it will have to be spread over time. An important part of the response must be a credible promise that budget discipline will be upheld, not just next year, but forever. The very political expediency that explains why deficits have been condoned for more than 35 years must be confronted head on. Greece must adopt a debt sustainability rule, as many countries have successfully done before.
Some will say that Greece already operates under the Stability and Growth Pact, an externally-imposed rule for budget discipline. Well, since 2001 when Greece joined the euro area, its deficit has never been below the 3% ceiling. Greece needs a more reliable mechanism. The best solution is to inscribe the rule in its constitution. A good rule either sets limits to the deficit or public spending, preferably both. It establishes an independent body that will verify the plausibility of budgets as submitted to Parliament, supervise their execution and, if need be, bring the matter to the highest court.
Perhaps another message should be sent to the financial markets. Technically, Greece is nowhere near defaulting. Market fears are just that – fears. Financial markets exist to deal with risk. Panicking when they perceive some manageable risk – thus creating havoc – is no more socially tolerable than ignoring risk when a huge one is looming (the behaviour that created the disaster that we saw last year).
Financial markets are not for the sissies, and if modern-day financiers are sissies, maybe the game that they play should be subject to adequate protective rules (serious regulation), and excessively virile play should be discouraged (a Tobin tax?).
Buergin, Rainer and Holger Elfes (2009). “Steinbrueck Says Euro States May Bail Out Members (Update2),” Bloomberg, 17 February.
Wyplosz, Charles (2009). “Bailouts: the next step up?” VoxEU.org, 21 February.