Greece And The Potential Upside In An IMF Rescue

Peter Boone and Simon Johnson have just written a post "Greece And The Fatal Flaw In An IMF Rescue," at Baseline Scenario which outlines three scenarios for the Greek economy going forward.

  1. True Fiscal Austerity… We doubt such an austere program could work, and even if it did, someone needs to finance Greece’s budget deficit, and roll over their debt, for 3 or more years.  Markets would undoubtedly be concerned by sharp output declines and ongoing strikes.  The only solution would be for the EU and IMF to step up, and effectively guarantee three years of financing needs, or $150bn in total.  That is seven times the whisper numbers that the European Union is currently considering providing to Greece.
  2. Sovereign default but keep the euro… This financial collapse would mean Greek debt would need to be written down substantially.  We would guess that a 65% write down of face value, bringing total Greek debt to around 50-60% of a lower new GDP, would be reasonable.  Such write downs roughly match the terms that Argentina received after its debt restructuring.
  3. The IMF’s Plan B – Debt default and exit the eurozone: Faced with a collapsing banking system that comes with default on sovereign debt, there is good reason to call for Greece to, at least temporarily, give up the euro.  The advantage of moving to a different currency would be that Greece could generate a rapid increase in competitiveness, and so speed up its transition.  The government could offer to restructure debt into this new currency, or into Euros at a much larger haircut.  The bloated costs of the public sector could be eroded through inflation in the new currency.  This should make it possible to quickly move to a budget surplus and an external surplus.

These three scenarios sound like a reasonable start for a baseline decision tree on the Greek sovereign debt crisis. They bring to mind my thoughts from January 2009 when I was more concerned with Ireland than Greece.

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

The Eurozone and the spectre of banking collapse

It’s funny how these events keep circling back around with different stress points for the same problems. Now it is Greece in the situation I envisaged beginning in Ireland – and Greece has a significantly higher debt load, which is why Johnson and Boone don’t believe austerity would work. I wouldn’t make as stark a statement and I want to revisit a few posts I wrote on austerity measures and the IMF to show why.

In "Anticipating Eurozone collapse," I wrote that I still believed a sovereign default within the Eurozone (Baseline Scenario 2) was most likely, followed by a bailout under austerity guidelines (Baseline Scenario 1), followed by a eurozone breakup (Baseline Scenario 3) as least likely. Unfortunately, I still believe Baseline Scenario 2 is the most likely outcome because of political constraints within the eurozone, especially in Germany. And I really find it hard to believe Baseline Scenario 3 would happen though the chances do seem to be increasing.

However, I want to talk about Baseline Scenario 1 which I see as a better outcome. This is the outcome we should be hoping for. When I described Baseline Scenario 1 in "The politicization of economic problems" in March, I said:

I suggest a two-stage approach. In the short-term, we would need a trust-but-verify approach that only the IMF could institute. Greece would continue as planned with the budget measures they have already enacted. However, the Greeks could, therefore, be assured that – should it face liquidity problems – the IMF would intercede and ensure the Greeks stick to their budgetary plan. From a political perspective this takes the heat off Germany and supports their austerity agenda. For the Greek government, it gets cover domestically: ‘we didn’t create this mess; the former government did.  And we’re not forcing the cuts; the IMF is. The key, of course, is that the IMF funds be available as a loan for temporary fiscal stimulus to support liquidity over the medium-term in exchange for concrete promises on longer-term budget issues. This would attenuate any economic pressure.

I said similar things in February. Simon and Peter, however, are talking about massive fiscal cuts and huge tax increases (likely to create serious capital flight, I might add). There is no way this is going to fly. So, on the face of it, their scepticism about this working seems warranted. 

But, does it have to actually be like this?  What about pensions?  Last June, when talking about a cake-and-eat-it-too US austerity scenario I wrote a post called "Means of deficit reduction: Medicare and Social Security" which basically said that the only real long-term deficit problem the U.S. government had was related to Social Security and Medicare/Medicaid liabilities.  I suggested raising the minimum age to collect benefits as a means of reducing the projected deficit. Honestly, this was not one of the more popular posts at Credit Writedowns, but I still feel strongly (particularly on Medicare, not so much on Social Security) that raising age requirements to collect is the easiest and most effective way of closing the gap amongst the four I outlined. The point is that a country can cut medium- and long-term primary deficits substantially this way.

In the case of Greece, the pension age is 63 (up from 61 earlier this year).  Meanwhile, in Germany the age is 67.  If Greece could get 4% loans from the IMF and/or EU sources, could raise the pension age to 67, and could take an additional 5% in fiscal measures, wouldn’t that work too?  How likely is this to happen?  Not very likely in my opinion.  But, I thought I’d throw it out there. My point is there are glide-path solutions that involve some form of long-term adjustment without killing the economy near-term.  Why aren’t people talking about those options?

One thing is for sure, while the Europeans want to make you think they put the loaded gun on the table, clearly only one bullet was in the chamber and they have now discharged their weapon. The plan they sketched out was the best we could have hoped for given the political constraints and largely reflected what I saw as necessary. Nevertheless, they must move from the ‘plan’ to the reality. Eventually their hand will be forced by markets. And 6.5% rates are not going to get it done.


Greece: 2009 Article IV Consultation—Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Greece – IMF, Aug 2009

  1. John Haskell says

    Yields on the GR 2 year went up 120 basis points yesterday. I think that is perhaps not the most eloquent, but certainly the most persuasive, answer to your question as to why GR can’t kick the can down the road with pension jiggling that will take effect years from now.

    1. Edward Harrison says

      John, I don’t see pension reform as jiggling. That is a very major part of fiscal austerity -ask the Germans who have done this. If the Greeks backload these reforms somewhat, it would be both credible to bond markets and less severe in the short-term.

      Cutting pensions is hard to do – and doing so is final. It is not prospective. When the law passes that pension ages have increased, this is a REAL cut, not a potential cut. That meets the austerity test then – and i imagine would satisfy markets, the EU and the IMF that Greece means business.

      At the same time, focusing somewhat on future pension liabilities (i.e. 2015 and beyond for example), it gives the Greeks breathing room in the short-term to rely less on fiscal cuts today to close their fiscal gap. That means less deadweight loss from recession.

      The point is to prevent a default, of course. And that means reducing funding needs via loans, lower rates, and short- and medium-term fiscal cuts. There are a lot of different combinations that get you there. The question is whether they are politically palatable.

      1. John Haskell says

        I think when you say “backload these reforms somewhat” perhaps you mean “front load”?

        If you don’t like the word “jiggling” that’s fine. However I think the problem cannot be solved by adjusting pension payouts, using whatever verb you prefer.

        Not only does the country need many billions of euros from the credit markets in the very short term, they have destroyed their international competitiveness. Last month I paid EUR 150 for a two day car rental and EUR 180 per night to stay in a bed and breakfast in Nafplio. For a country as dependent on tourism as Greece is, where do you get the tax revenue?

        You can’t make people travel to Greece. One of the hotel owners (herself English) said that Greece was now the most expensive “sun and sand” destination in the world if you are departing from the UK.

        I think yesterday’s bond market action (more or less validated by today’s) shows that the market has put GR on a much shorter fuse than was thought even a week ago. This will go down just like Russia ’98 or Argentina ’01: a “sudden stop” in funding, followed by a realization in Berlin that Greece needs EUR 150 billion, followed by revulsion and refusal to bail GR out.

        As a final note I just want to say that Wolfgang Munchau shows (indirectly) how this will happen. If he thinks GR will default next year, who will be so brave as to lend to GR this year, unless at a 100% interest rate?

        1. Edward Harrison says

          John, you and I both know that Munchau is probably right on Greece. And as an investor you don’t want to be owning the stuff. That’s one reason yields are backing up. While I am presenting a best case scenario, I am sensitive to the realities.

          You’re right about cost competitiveness too. And logically there are only two ways to achieve better competitiveness:

          1. Devalue the currency
          2. Decrease wages across the board.

          Since the Euro ties Greece’s hand on the currency, internal devaluation is the only option. Edward Hugh’s points on Spain speak to this:

          The problem is Spain can only create jobs through exports. The problem is, with Brussels prices we cannot attract investment to build new factories to create high volume unskilled employment. At this stage in the game we are not in competition with Brussels, but with Bratislava. That may not be a pleasant truth, but it is simply like that. We have attracted a large quantity of people here to work in unskilled low-value employment. The industry that gave them work just permanently disappeared out of sight. We need, urgently to find alternatives since we cannot pay them all 420 euros a month for ever. This is more than a simple academic exercise, it is now a question of life and death for the Spanish economy.

          Basically we need to go back to 2000 wages and prices and start again. Maybe you don’t like this idea, but can you point me to anyone who has an alternative?”

          Unfortunately, I see similar factors at play in Greece.

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