Economic Journal, February 2021, with Harris Dellas. PDF.
We study the optimal debt and investment decisions of a sovereign with private information. The separating equilibrium is characterised by a cap on the current account. A sovereign repays debt amount due that exceeds default costs in order to signal creditworthiness and smooth consumption. Accepting funding conditional on investment/reforms relaxes borrowing constraints, even when investment does not create collateral, but it depresses current consumption. The model contains the signalling elements emphasised by creditors in the Greek austerity programmes and is consistent with the reduction in the loans issued by Greece and their interest rate following the 2015 election.
Economic Journal, forthcoming, with Harris Dellas. PDF.
We study the optimal debt and investment decisions of a sovereign with private information. The separating equilibrium is characterized by a cap on the current account. A sovereign repays debt amount due that exceeds default costs in order to signal creditworthiness and smooth consumption. Accepting funding conditional on investment/reforms relaxes borrowing constraints, even when investment does not create collateral, but it depresses current consumption. The model contains the signalling elements emphasized by creditors in the Greek austerity programs and is consistent with the reduction in the loans issued by Greece and their interest rate following the 2015 election.
In a Peterson Institute policy brief, Paolo Mauro and Jan Zilinsky argue that
the evidence is mixed: Those who hold a prior that fiscal adjustment is harmful for growth may find their beliefs confirmed, whereas those who believe a prior that the link is weak may find the evidence unconvincing (even aside from valid concerns about causality). To the extent that the case of Greece involves unique features beyond large fiscal adjustment, the data reveal that drawing conclusions from empirical associations that include this specific case requires caution.
it is important to recognise that the headline debt figure overstates the true burden of Greek debt. Because most of the debt is owed to official sector partners at concessional interest rates, the interest burden is much lower than would usually be associated with the same gross debt. Under the Fund’s own criterion for sustainability in these circumstances (ratio of gross financing needs to GDP), Greek debt should remain within an acceptable range at least through 2030. It is questionable to base debt relief policy on problems that might or might not materialise beyond such a distant horizon. Moreover, most of the projected sharp increase in debt could be avoided by carrying out bank recapitalisation directly from the European Stability Mechanism (ESM) to the banks, rather than through the Greek government as an intermediary.
There is still an important potential role for using interest rate relief, for two purposes. First, if fiscal balances fall below target because of lower than expected growth (rather than policy slippage), a portion of interest otherwise accruing could be forgiven to avoid the need for additional fiscal tightening and its recession-aggravating consequences. Second, because Greek unemployment is at depression levels (26%), special employment programmes would seem appropriate, and forgiving a portion of the interest due could provide a significant source of funding for this purpose.
Cline also discusses the claim that Eurozone loans mainly saved Eurozone banks:
not true, they received only one-third of the official sector support;
that the Troika called for too much austerity:
true, the cyclically adjusted primary balance swung from -13.2% of GDP in 2009 to +5.3% in 2014, much more than in Portugal, Spain or Ireland;
but Greece was cut off from financial markets;
and Eurozone support as a share of GDP exceeded 100% in Greece compared with roughly 30% in Ireland and Portugal or 5% when the US supported Mexico;
“even at the upper bound of the IMF’s upward-revised multipliers (1.7), smaller spending cuts would not have boosted GDP and revenue by enough to pay for themselves;”
and the adjustment mostly occurred in the early years when spreads were high and would have been even higher with less adjustment.
Cline estimates that the third rescue package will raise Greek net debt by 10-15 billion Euros.
In a Project Syndicate column, Edmund Phelps argues that it is not “austerity” which is to blame for Greece’s plight.
So spending more is not the remedy for Greece’s plight, just as spending less was not the cause. What is the remedy, then? No amount of debt restructuring, even debt forgiveness, will suffice to achieve prosperity (in the form of low unemployment and high job satisfaction). Such measures would only help Greece to revive government spending. Then the economy’s stultifying corporatism – clientelism and cronyism in the public sector and vested interests and entrenched elites in the private sector – would gain a new lease on life. The European left may advocate that, but it would hardly be in Europe’s interest.
The remedy must lie in adopting the right structural reforms. Whether or not the reforms sought by the eurozone members raise the chances that their loans will be repaid, these creditors have a political and economic interest in the monetary union’s survival and development. They should also be ready to help Greece with the costs of making the necessary changes.
In a Vox blog post, Olivier Blanchard addresses four critiques against the IMF’s engagement in Greece. He argues that
the 2010 program did help Greece; without it, Greece would have undergone much harsher “austerity;”
the financing given to Greece did not only benefit foreign banks; the 2012 PSI amounted to debt relief on the order of 10’000 Euro per capita;
“[m]any … reforms were either not implemented, or not implemented on a sufficient scale … [m]ultipliers were larger than initially assumed … [b]ut fiscal consolidation explains only a fraction of the output decline”;
conditionality also reflects political constraints on the part of the lender countries.
Olivier sees the Fund on the sidelines, in particular after Greece’s default against the IMF:
The role of the Fund in this context is not to recommend a particular decision, but to indicate the tradeoff between less fiscal adjustment and fewer structural reforms on the one hand, and the need for more financing and debt relief on the other.
Ashoka Mody argues in an Econbrowser blog post that recent IMF research should guide a Greek deal. According to Mody this research shows that debt overhang is very costly; “austerity” can be self defeating; and structural reforms generate uncertain payoffs. He therefore recommends
large scale debt relief, resulting in a debt quota of 50%,
a scale down of the banking system, and
a primary surplus quota of 0.5% over the coming years.
Olivier Blanchard, IMF chief economist, disagrees.
Chris Gilles reports in the FT about Olivier Blanchard’s plans to retire as IMF chief economist. Olivier emphasized the importance of academic research and challenged the Washington consensus. Under his watch, the IMF
questioned the benefits of unrestricted capital flows;
suggested higher inflation targets;
emphasized costs of “austerity.”
As the article points out not all of these initiatives were successful.
In a Project Syndicate column, Yanis Varoufakis argues that negotiations between Greece and European and international partners have “brought about much convergence.” Disagreements remain. His government believes that due to policy mistakes in the last few years Greece has been caught in an “austerity trap” and a “reform trap.”
Greece’s official creditors have granted it long enough grace periods and low enough interest rates that the [debt] burden is bearable. Greece … spends less on debt service than Italy or Ireland, both of which have much lower (gross) debt-to-GDP ratios.
… only governments with access to market finance can use expansionary fiscal policy … it is disingenuous to claim that the troika forced Greece into excessive austerity. Had Greece not received financial support in 2010, it would have had to cut its fiscal deficit from more than 10% of GDP to zero immediately. … the troika actually enabled Greece to delay austerity.
In a Vox column, Thomas Philippon suggests a 3% rather than 4.5% primary surplus target on fairness grounds. His central points are:
Greece ran a reckless fiscal policy during the boom years, wasting much of the money that it received. There is no question that Greece needs a strong dose of fiscal consolidation. However, Greece’s debt should have been restructured much earlier. This restructuring was prevented by legitimate fears of contagion, and it is not fair to ask Greece to pay for that delay, which reflected a general lack of preparedness among Eurozone policymakers.
CEPR Discussion Paper 10315, December 2014, with Harris Dellas. PDF. Also published as CESifo Working Paper 5146, Study Center Gerzensee Working Paper 14-07. PDF, PDF.
We shed light on the function, properties and optimal size of austerity using the standard sovereign debt model augmented to include incomplete information about credit risk. Austerity is defined as the shortfall of consumption from the level desired by a country and supported by its repayment capacity. We find that austerity serves as a tool for securing a more favorable loan package; that it is associated with over‐investment even when investment does not create collateral; and that low risk borrowers may favour more to less severe austerity. These findings imply that the amount of fresh funds obtained by a sovereign is not a reliable measure of austerity suffered; and that austerity may actually be associated with higher growth. Our analysis accommodates costly signalling for gaining credibility and also assigns a novel role to spending multipliers in the determination of optimal austerity.
The Economist’s “schools briefs” on the financial crisis: Parts 1, 2, 3, 4, 5. Quoting from the first part:
… it is clear the crisis had multiple causes. The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also bear blame, for it was they who tolerated this folly. The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growth—fostered complacency and risk-taking. A “savings glut” in Asia pushed down global interest rates. Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky world.