Greece Does Not Have To Go Bust

The Greek government has won the vote on further austerity measures and thereby cleared the ways for further funds from the European Union and the IMF. This has avoided a melt-down of the European financial system with devastating consequences for the world economy, but the financial pundits keep claiming that Greece is insolvent and will have to default sooner or later. This kind of loose talk makes solving the Greek crisis more complicated, because it maintains unsustainable high interest rates for the Greek and other Southern economies.

The Hellenic Republic does not have to go bankrupt. Whether Greece is solvent or has a liquidity problem depends on how you look at it. Solvency requires that present liabilities will be repaid by future primary budget surpluses and this depends on budget policies and on the macroeconomic environment in which they are executed. In principle, a sovereign has the right to tax and cut spending, but if taxpayers become unwilling to pay, public debt becomes unsustainable for political reasons. This is now the threat in Greece. However, the sustainability of public debt does not only depend on political will, but also on the macroeconomic environment.  When interest rates are excessively high and GDP shrinks, the debt service will become unbearable.

These factors are complementary and do not exist independently from views and judgments about a state’s public finance. For example, the simple perception of a state as insolvent, even if it is not actually the case, may cause a liquidity crisis that pushes up interest rates, lowers growth and government revenue, and thereby causes a default that then translates into insolvency. Public debt dynamics work like quantum mechanics: an observed object is transformed by its observation.

Economic theory does provide a theory how the “quantum mechanics of public debt” will lead to sustainable debt ratios. A famous rule says that in long run equilibrium, growth and interest rates should converge, implying that the debt service is tending to zero. In this case, a positive primary balance would be sufficient to reduce debt ratios.

The problem with Greek fiscal policies was that primary surplus (the difference between revenue and spending net of debt service) shrank and turned negative in 2003, despite negative debt service. For this deterioration the previous Karamanlis government was responsible. But today’s problems of the Hellenic Republic are due to the high debt service, which is  close to 15% of GDP. Given a primary deficit of 10%, this situation would require a daunting 25% of GDP consolidation program. No wonder people are demonstrating in the streets.

There is growing evidence that the conditions imposed on Greece by Germany, and subscribed to by the other member states, are “a case of medicine doing more harm than good”. Even the IMF lends to Greece at more favorable terms than the European Union. According to the European Commission, GDP in Greece has fallen over the three year period 2009-2011 by 10%, private consumption by 13.2%, and investment by 44.8%. Exports have fallen by 20.1% in 2009 and are expected to increase by the end of 2011 by 14.5%. On the other hand, public consumption increased in 2009 by 10.3% and is now down by 9.1%. One does not have to be a blue-eyed Keynesian to understand that the contraction of all demand components will shrink income and tax revenue and thereby push Europe into the abyss of a debt crisis.

Two things would have to happen in order to bring down Greek debt ratios: (1) a positive primary balance, which according to the IMF will be reached in 2012. (2) Interest rates must again come down to a level close to German rates. These two minimal conditions are sufficient to ensure that Greece remains solvent. If we assume conservatively that economic growth rates will exceed 1 % and inflation will be close to the ECB target of 2%, German interest rates of 3% would reduce the debt service to zero.  If more realistically Greece would return to its long term potential growth rate of 3%, the situation looks even brighter. The only condition on which the sustainability of Greek debt ratio will then hinge is a primary budget surplus and this is far more feasible than the present massive adjustment program.

This is where European solidarity comes in. Instead of imposing ever harsher conditionality for bailout money, which will ultimately be lost, the European Union must declare that it will not allow Greece to default under any circumstances and will provide all the necessary liquidity for rolling over debt as it matures. Risk premia and interest rates will then quickly start to come down.

However, to avoid moral hazard, the fiscal autonomy of a member state that makes use of such a guarantee must be constrained. The Stability Pact must be reformulated with the aim of permanently achieving primary budget surpluses. And all member state governments must declare solemnly that they do this in their own national interest and for the sake of all European citizens.

However, the real question in Europe is, whether the limitation of national sovereignty can be dictated by the largest member state, or whether this is a common European concern, which would require that the Commission, the Council and the European parliament take over for the period of such loan guarantee. I believe that if a member state needs the collective support of the Union, involving potentially contributions by all European taxpayers, then they should have the collective authority to decide how to solve the crisis.

Hence, it is possible to avoid Greek debt restructuring and this is in the interest of all European citizens. The problem is the pernicious influence of nation states. It is time that European citizens take power back in their hands and start to manage their common interests collectively. This is called solidarity.

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