Tag Archives: Debt overhang

Does Greece Need Official Debt Relief?

In a Peterson Institute working paper, Jeromin Zettelmeyer, Eike Kreplin, and Ugo Panizza conclude that the answer to that question depends on your assumptions.

The authors compare several scenarios, including

  • scenarios A–C, the baseline scenario of the European institutions and two more pessimistic variants;
  • scenario I which underlies the IMF reasoning and which assumes that “Greece will not undertake the structural reforms needed to achieve higher potential growth”;
  • and scenario D, which corresponds to what Greece committed to when the third program was agreed, and which represents the German position.

They assume that interest rates on privately held debt rise with the debt-to-GDP ratio, and they use two “sustainability” metrics: The debt-to-GDP ratio (should fall), and gross financing needs as a share of GDP (should be smaller than 20%).

When running Monte Carlos simulations, the authors find that for each scenario, the assumptions about growth and primary surpluses are consistent with the conclusions drawn by the different institutions:

  • In A (borderline) and D, debt is “sustainable.”
  • Not so in B, C, and I, due to “accelerating substitution of official debt by more expensive borrowing from private sources”.

The authors then evaluate the plausibility of the scenario assumptions. They conclude that “international evidence does not support an adjustment path that envisages a primary surplus of above 3.5 percent for more than three to four years on a continuous basis and for more than seven years on an average basis” rendering B and C the most plausible scenarios, and suggesting that the debt is “unsustainable.”

In reaching their conclusions, the authors assume that primary surpluses in Greece will react to debt, inflation, and growth in line with the experience in other (developed) economies. (This means, for example, that surpluses rise as the debt burden increases, which seems to contradict the notion of debt overhang.) This is unconvincing, of course, if one takes the view underlying scenario D which presumes that feasible promises are kept. Or stated differently: Greece might well be able but not willing to pay—after all, in this very case official creditor intervention could have made sense in the first place although private lenders charged high interest rates. (With Harris Dellas, we make this argument precise in a paper in the Journal of International Economics.) Related, one can think of many reasons why the historical experience in other countries may be uninformative for the Greek case. The authors address one concern: They focus on episodes with very high debt-to-GDP ratios and find that in these cases, primary surpluses are maintained for longer. Moreover, there is the important question of measurement: The Greek debt-to-GDP ratio is not easily comparable with the ratio in other countries, see here and here, and most likely overstated.

Zettelmeyer, Kreplin, and Panizza make the case for a delay of Greece’s return to capital markets. In the conclusions, they write that

the debt relief measures put on the table by the Eurogroup in May 2016 could be sufficient to restore debt sustainability, but only if these measures are taken to an extreme. This means accepting an extremely long maturity extension of EFSF debts. In addition, it requires either substantial additional interest rate deferrals, or locking in significantly lower funding costs and hence lower interest rates than the EFSF currently expects, or a combination of both. While these measures are feasible within the red lines described by the Eurogroup, they are likely to be politically and/or technically difficult. Unless the EFSF manages to eke out substantial extra interest relief through creative long-term funding operations, its exposure to Greece will likely have to rise, possibly for decades, before it starts falling. A private sector creditor would not accept this type of restructuring because it gives the debtor country a strong incentive to default (or at least renegotiate) when the debt is at its peak.

… one way out of this dilemma would be to delay Greece’s return to capital markets, continuing to finance Greece through ESM programs until its private sector spreads are much lower than they are now. … this approach would lower the total need for debt relief and/or fiscal effort required to restore Greece to debt sustainability. While it would lead to a significant increase in official creditor exposure to Greece—requiring perhaps €100 billion of extra ESM financing—this is less than the rise in EFSF exposure that would be required in the Eurogroup’s approach, which aims to return Greece to private capital markets in 2018 while relying mainly on EFSF maturity extensions and interest rate deferrals … total official exposure to Greece would decline faster if ESM financing were to continue than if it were to end in 2018.

Importantly, they also point to the incentive effects of debt restructuring:

If [the threat of Grexit is essential to maintain incentives for reform] keeping the sword of Grexit … would help reduce debt levels only so long as Greece is being financed with cheap official funds. If, however, Greece returns to capital markets, any beneficial incentives of this approach would likely be offset by the risk premiums that private lenders would charge to a country whose euro membership remains at risk.

The official creditors will have to make up their minds: Not only the return on their lending is at stake, but also reform in Greece.

“Sovereign Debt with Heterogeneous Creditors,” JIE, 2016

Journal of International Economics 99(S1), March 2016, with Harris Dellas. PDF.

We develop a sovereign debt model with heterogeneous creditors (private and official) where the probability of default depends on both the level and the composition of debt. Higher exposure to official lenders improves incentives to repay due to more severe sanctions but it is also costly because it lowers the value of the sovereign’s default option. The model can account for the co-existence of private and official lending, the time variation in their shares in total debt as well as the low rates charged on both. It also produces intertwined default and debt-composition choices.

IMF Research and Greece

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.

Parallels between Argentina and Greece

On Project Syndicate, Raquel Fernández and Jonathan Portes offer four lessons from the Argentinian default in 2001 for Greece:

… if the economics are on your side, you can and should ignore politicians prophesying disaster. … a short period of political turmoil can cost surprisingly little compared to a long period of mindless pursuit of misconceived policies. But … Greece must acknowledge that its fundamental problems are of its own making. … Greece is unlikely to enjoy the breathing space provided by a commodity boom. If it is to place itself on the road to a sustainable recovery, it has no time to lose.

Ken Rogoff on Martin Wolf’s “The Shifts and the Shocks”

In Prospect Magazine, Ken Rogoff reviews Martin Wolf’s account of the financial and European debt crises as well as his policy conclusions. Along the way, he offers his own views. Some excerpts:

Wolf rightly believes that one needs to look at the entire global economic system to understand what happened.

… he essentially concludes that there will be no long-run financial stability without kicking banks out of the money creation business, leaving it as a government monopoly, much as leading “Chicago Plan” economists first suggested in the 1930s.

Although Wolf makes a coherent case for considering this radical reform [the Chicago plan], he is rather circumspect on just how bad things will be if we don’t do it. For one thing, he seems to agree with Chicago economist Robert Lucas (whom he otherwise sharply critiques) that if the US financial firm Lehman Brothers had not been allowed to fail, the financial crisis would have been far less acute.

But if one really believes this, then why take all the risks of radical change? Anyone advocating a radical fix, as Wolf does, needs to convert the many politicians, financiers, regulators and even academics who conclude that the real lesson of the crisis should be to never let big banks fail. (This is certainly not my position.)

… By mulling whether the crisis could have been mitigated simply through better tactics during the weekend of 13th-14th September 2008, Wolf undermines his own case for radical reform. To be clear, I think that a major financial collapse would have been very difficult to avoid regardless of how Lehman was handled. Thus Wolf is fundamentally right: radical change is needed. Turning to the eurozone, … He is right that Germany bears its share of responsibility. But he emphasises the potential role of German fiscal stimulus far too much, and correspondingly underestimates the importance of regulatory failures, the rigidity of the 2 per cent inflation target and, above all, northern recalcitrance to restructure and write down southern debts.

… The first problem with Wolf’s simple arithmetic is that Europe is not a closed economy, and indeed Germany depends vastly more on exports to China and the US than exports to the periphery.

… If the capital flows to the eurozone periphery had been mainly in the form of direct foreign investment or equity (instead of short-term debt), they would have been far less problematic. … Germany’s biggest mistakes, by far, were in financial regulation that produced instability.

In truth, the southern Mediterranean countries in Europe are a place where there really is secular stagnation … But secular stagnation in the periphery would have been happening with or without the financial crisis … what could Germany have done? … First, it should have acted earlier to take a euro break-up off the table. Second, it should have found a way to restructure periphery debts at lower interest rates and with more time to repay. Third, it should have moved earlier to endorse a looser monetary policy at the European Central Bank (ECB). Fourth, and more for itself, it should have expanded infrastructure investment at home and abroad.

… rather than pouring fiscal stimulus into a German economy that has for some time arguably been overheated, it would have been far better to give periphery countries more help. … The point that periphery countries suffer from debt overhang should be an obvious one by now …

Wolf finds convincing the comparison between Spain and the UK made by the Belgian economist Paul De Grauwe, who argues that Spain would have been in much less trouble if it had had its own currency. True, but misleading. The claim overlooks the fact that, in many ways, Spain has still not completed the transition from being an emerging market to being an advanced economy. … But governance and institutional development can take many generations to unfold. My overwhelming presumption is that these countries would still have had problems containing their debts. … It is ludicrous to think the periphery has a mere liquidity problem. That is why the debts needed to be written down, or more likely stretched out at lower interest rates, which amounts to the same thing.

… So Germany could have done more to alleviate the crisis in the periphery. But the best way was not to increase spending in Germany, but to help increase spending in the periphery. Even the IMF has finally reached this epiphany, arguing that it should have insisted on “bailing in” private creditors in Europe; that is, making lenders take losses. Instead, too much of its lending effectively just helped to pay off private creditors, and did not provide meaningful budget relief.

Anyone worried about austerity in the periphery should have been first and foremost focused on writing down debt. The idea that arguing for such policies, and that worrying about the effects of debt overhang on growth, amounted to favouring “austerity” is simply ludicrous.

… Austerity in the periphery eurozone is an entirely different animal to that seen in the US and UK. The eurozone periphery suffered a classic sudden stop in private lending, and although the “troika” of the IMF, European Commission and the ECB did step in to help, they were too limited in their willingness to write down debt. Facing a sudden withdrawal of financing, periphery countries had to reduce expenditures.

For the US and UK, the decision to expand and then gradually reduce deficits gave policymakers considerable discretion over the exit strategy. For these countries, one can meaningfully speak about the trade-off between stability and stimulus….

Another key pillar in recovering from a financial crisis should be to boost infrastructure investment. Virtually every economist of every stripe agrees with this recommendation. … Administration officials privately expressed concern that infrastructure projects would take too long to get off the ground, and by the time they did, the spending would no longer be needed. My book with Carmen Reinhart, This Time Is Different, suggested that the recession was likely to be around for a long time, and that infrastructure spending would be extremely helpful.

… In fact, the ostensible argument over debt has nothing to do with progressive and conservative differences. It is about the size of government.

… The financial crisis does create an additional and very important argument in favour of fiscal stimulus, and Wolf is absolutely correct to highlight it. When an economy is at the zero bound on interest rates, and the central bank is unable or unwilling to stimulate inflation, fiscal policy is more effective in raising output. … However, the empirical size of the “fiscal multiplier” (how much output rises relative to increased government spending) is widely debated, and the evidence is very thin. … The fact the UK and US both achieved solid growth in the face of fiscal cuts would seem to contradict the view that multipliers are always and everywhere very large.

… Wolf, in line with Krugman, appears to believe that even wasteful government spending would raise welfare, a claim that is at best debatable.

… As for the resulting debt burden not being an issue, it is far from obvious that governments were wrong to worry about the fiscal burden, as debt more than doubled within a very short time. The ability to issue large amounts of debt in response to crises is a valuable option for governments. But if a country’s debt starts to reach a situation that is perceived as risky, the option might not be as available when needed most.

… Wolf now argues that of course we all knew there would eventually be a vigorous recovery in the UK. I can only say this was not obvious from reading either the Financial Times or the New York Times. Again, this is a matter of calibration, and the awful forecasts of those who focused excessively on fiscal policy and nothing else, underscores how difficult real-world policymaking can be.