Info Service on Finance and Development (Mar12/05)
Geneva, 28 Feb (Kanaga Raja) - Although the recent agreement reached by Greece for 130 billion euros in lending should allow the government to avoid default in March, there are grave doubts as to whether the agreed upon programme will lead the country to a point where it returns to growth, has a sustainable debt burden, and can borrow from private markets.
The option of a planned default and exit from the euro should be taken seriously for Greece as an alternative to the current projected scenarios.
This is the assessment of the Washington-based think tank the Center for Economic and Policy Research (CEPR), which argues in a paper that such an outcome might happen in any case due to recurrent crises and continued recession.
The paper, titled "More Pain, No Gain for Greece: Is the Euro Worth the Costs of Pro-Cyclical Fiscal Policy and Internal Devaluation?", was authored by Mark Weisbrot, CEPR Co-Director, and Juan Antonio Montecino.
In a CEPR press release, Weisbrot said: "The IMF has consistently underestimated the depth of the Greek recession. At some point, it becomes rational to ask, is the euro worth this kind of punishment?"
According to the CEPR paper, since May of 2010 Greece had been operating under an agreement with the International Monetary Fund (IMF). The terms of this agreement are decided by what has come to be described in the press as "the troika" - the European Central Bank (ECB), the European Commission, and the IMF - in negotiations with the Greek government.
The ostensible purpose of the agreed upon policies is to reduce Greece's fiscal deficit and debt to a sustainable level, implement "structural reforms" that are alleged to make the economy more efficient and competitive, and allow government finances to recover to the point where Greece can return to borrowing from private financial markets at sustainable interest rates.
"Yet nearly two years later, the economic situation of Greece has become drastically worse," says the paper.
Greece is now in its fifth year of recession. In the IMF's "Fifth Review Under the Stand-By Arrangement" published in December 2011, the Fund projects that Greece will lose a total of 14.4 percent of GDP from its peak in 2007 to a projected trough in 2012. This is a large loss of income and compares to some of the worst downturns associated with financial crises in the 20th and 21st centuries.
Adjusting the IMF numbers in accordance with the most recent data gives us a total output loss of 15.8 percent, say the authors.
However, there are a number of reasons to believe that the losses could be considerably greater. First, the IMF has consistently underestimated the depth of Greece's current recession. The most recent projection for 2012 GDP made in the IMF's fifth review, is a huge 6.9 percent below the projection in the first review (published in September 2010). More ominously, two-thirds of the drop in projected growth since the first review has been quite recent and sudden, in the five months between the fourth and the fifth review.
Projections for unemployment in 2013 have increased between the first and fifth review by more than a third, from 14.5 percent to 19.5 percent. These are sure to be revised upward soon, since October 2011 unemployment already hit 19.2 percent; by the national Greek measure, the unemployment rate is currently even higher, reaching a record 20.9 percent in November.
According to the paper, the IMF projections also rely heavily on large revenues from privatisations - about 35 billion euros, or 15.4 percent of GDP over the next two years. This is part of a total of 22 percent of GDP from privatisations, which has now been pushed back to 2017.
But these are very likely to fall short of targets, as they have so far. If even a third of the privatisations do not happen in the next two years, this means that the government would have to come up with another 5 percentage points of GDP in revenues - or similar cuts on the spending side to meet the programme targets for the debt/GDP ratio.
Finally, say the authors, it is worth noting that the projected recovery of Greece is so slow - unlike other financial crises characterized by large losses of output - e.g. Argentina (1998-2002) or South Korea (1997-1998) - which were followed by rapid recovery, that Greece is expected to take more than a decade to reach its pre-crisis level of GDP.
"One of the biggest and most basic problems facing Greece under the IMF program is that the measures that the government is adopting are pro-cyclical. In other words, the fiscal tightening reduces aggregate demand in the economy, causing the economy to shrink further. This reduces government revenue, since tax payments fall with income. There are also some components of government spending, such as unemployment insurance, that increase automatically when the economy is shrinking. This will make the fiscal target even more difficult to achieve."
If GDP is shrinking, then cutting spending, for example, by percent of GDP will not improve the fiscal balance by the same percentage, because by the next year the denominator (GDP) is smaller. This is important to keep in mind, because the government is taking measures to cut spending that are much bigger than what shows up in spending reduction as measured by the share of GDP.
In 2011, for example, the government cut spending by 4.1 percent of GDP, but this only resulted in spending being reduced by 1.9 percent of GDP, because of the large fall in GDP throughout the year.
For 2010 and 2011, the authors note, there were spending cuts totalling 8.7 percent of GDP. These are enormous cuts - for those who are used to thinking about the US economy, imagine the federal government eliminating about $1.3 trillion of spending in just two years.
For the current year, 2012, the programme - according to the IMF's fifth review - is targeting 2.8 percent of GDP in new budget tightening measures. Much of the proposed increase in revenue for 2012 is in the form of tax collection on high-income taxpayers who have evaded taxes. Since tax evasion by the wealthy is a major structural problem in Greece, this is one positive aspect of the adjustment programme, says the paper.
However, the rest of the revenue comes mainly from privatisation, which is problematic; and also because it will result in a loss of assets that belong to the public, probably sold off at low prices, and that in some cases have more to contribute to the economy and/or public revenue if left in public hands.
According to the paper, one of the biggest and worst social costs of the current programme is the enormous loss of jobs. Unemployment hit a record 20.9 percent in November. By 2016, it is still projected to be at 17 percent, far above the 7.7 percent pre-crisis level, and a level that is generally seen as a national tragedy. The government has committed to cut 150,000 jobs from public employment for 2010-2015, about 22 percent of public employment.
The current negotiations appear to have reached agreement on a cut of 22 percent in the minimum wage, with 32 percent for workers under the age of 25. The minimum wage in Greece is about 880 euros a month. This will hit these wage earners quite hard, and have a significant impact on income inequality and poverty.
According to the authors, the economic theory behind the adjustment programme adopted by Greece is that of "internal devaluation," which is mentioned in the IMF's fifth review in describing the expected weak, slow recovery from Greece's deep and prolonged recession. It is not clear that "internal devaluations" are ever successful, at least compared to feasible alternatives. In theory, the deep recession and unemployment drives down wages enough so that the country's unit labour costs fall and it becomes more competitive internationally.
Other policy changes are also designed to drive down wages: the minimum wage cuts and weakening of collective bargaining. The country can then grow through demand for its exports, despite the weakness of internal demand. Domestic consumption and investment would be expected to recover, in this situation, when fiscal deficits and the public debt are brought down to a sustainable level.
"After four years of recession, with unemployment more than tripling, there appears to be no progress in Greece toward accomplishing an ‘internal devaluation'," the authors underline, noting that the Real Effective Exchange Rate based on Unit Labour Costs, according to the IMF, was slightly higher in 2010 than it was in 2006; based on the Consumer Price Index (CPI) it was about 6-7 percent higher in January 2011 as compared with 2006.
"In other words, four years of recession and relentless downward pressure on wages have failed to depreciate the currency in real terms for Greece... Despite the enormous economic and social costs that have already been incurred, and more forecast by the IMF, a successful internal devaluation has not yet even begun, and is nowhere in sight."
The IMF's Fifth Review, and the current negotiations with the troika, are based on the premise that debt will follow a path from its current 161 percent of GDP to 120 percent of GDP by 2020.
The main questions that the paper's authors say they are concerned with here are: (1) how likely is this progression to the target debt/GDP ratio to take place under the current programme?; (2) Will this path result in a sustainable debt burden, or are there likely to be more economically damaging, recurring crises along the way, even if the targeted path is eventually achieved?
The original IMF baseline projection shows the debt reaching a peak at 161 percent of GDP last year and declining to 120 percent of GDP in 2020, which the IMF considers sustainable.
Taking this as the troika's latest official projections, the paper says that there are so many downside risks that it is not easy to imagine that this latest baseline scenario would play out. The scenario could easily be derailed by lower economic growth. As noted above, the IMF's growth projections have been consistently and increasingly off the mark.
"With the euro-zone economy now shrinking, and the European authorities showing little inclination to adopt the counter-cyclical macroeconomic policies that would promote a recovery, there are big external risks to the underlying projected growth rate of the IMF's most recent baseline scenario."
The Fund notes that failures with privatisation, which have been the pattern so far, would alone raise the debt/GDP ratio from the targeted 120 percent in 2020 to 138 percent of GDP.
Official government figures released recently show that in 2011 GDP contracted more than what was assumed in the IMF's baseline projections: 6.8 percent instead of the projected 6 percent. Moreover, the IMF has also said that it expects 2012 growth to come in lower than what is currently projected.
The authors said that their revised baseline projection incorporates these developments while maintaining all of the other IMF assumptions in place. The revised growth numbers on their own are enough to push the level of debt as a percent of GDP in 2020 to 129 percent. In other words, even assuming near universal participation by bondholders in the debt swap and keeping all other parameters unchanged, Greece would still miss the 2020 target of a gross debt level of 120 percent of GDP.
"However, in light of the magnitude of the fiscal adjustment being undertaken in Greece and the IMF's consistent failure to adequately consider the full recessionary impact of tightening, even our revised baseline may turn out to be overly optimistic. That is why we also present a third ‘growth shock' scenario assuming a deeper recession in 2012 than what is currently forecast and slightly lower subsequent growth. Growth is lowered by one standard deviation, or 2.5 percentage points in 2012 and the shock subsequently decays by 2/3 every subsequent year. The scenario also allows the impact of growth to feed back into revenue, making it harder for the government to meet its primary balance targets as the recession lowers tax revenue."
According to this alternative scenario, which keeps all other assumptions unchanged, the overall debt level would only decline to 144 percent of GDP by 2020, well above the 120 percent of GDP level considered sustainable by the IMF, the paper underscores. It notes that it is important to keep in mind that it is not only the debt/GDP ratio that matters for debt sustainability, but also the interest burden of the debt. This is currently at 6.8 percent of GDP for 2011; under the assumption of a successful debt swap agreement, including a haircut now estimated at 100 billion euros, this drops temporarily to 4.9 percent of GDP for 2012; but it bounces back up the next year and remains over 6 percent through 2015.
The only countries that even have interest payments surpassing 4 percent are Italy and Portugal. In the entire world, there are only a handful of countries with a higher interest burden than that of Greece. And it is questionable whether these debt burdens are sustainable, as, for example, in Jamaica.
As this paper goes to publication, say the authors, the anticipated agreement between the Greek government and the troika for the 130 billion euro loan installment has been reached, after protracted negotiations. Given the track record of previous projections, the impact of pro-cyclical policies and the shrinking economy of the euro-zone, and all of the downside risks and problems that have been discussed in this paper, it appears that this latest agreement, even with the anticipated debt restructuring and 100 billion euro debt write-off, will be highly unlikely to provide a sustainable debt trajectory for Greece.
"From the above discussion it is clear that the IMF/troika program of the last two years has failed to move Greece closer to recovery, and in fact has made the economy worse. The most important cause of failure is of course the pro-cyclical fiscal policy. Given that Greece, under the euro, has no control over its monetary or exchange rate policy, the negative impact of pro-cyclical fiscal policy was pretty much predictable and predicted. And the country's economic prospects going forward, as noted above, do not look much better."
According to the paper, there are plenty of good alternatives if the European authorities were interested in a speedy recovery in Greece. In December, the ECB loaned $638 billion to European banks, at one percent interest. It will soon make some hundreds of billions of dollars more available to the banks. The ECB, if it wanted to do so, could facilitate a debt write-off bigger than the one that is currently being negotiated, and with very low-interest loans, allow for Greece to pursue a fiscal stimulus and recover relatively quickly.
But at present there is no sign that the European authorities are going to go in this direction. In fact, the ECB at this point is not even willing to accept the debt write-down that the private sector bondholders are expected to accept - a rigidity that appears extreme in light of the situation.
"It is therefore worth considering what might happen if Greece left the euro and defaulted on its foreign debt," the authors suggest. "The closest historical example we have to such a default and devaluation is Argentina in 2001-2002."
After unsuccessfully pursuing an "internal devaluation" through a three-and-a-half year recession, losing about 16 percent of GDP and accumulating an unsustainable debt burden in the process, Argentina defaulted on its sovereign debt in December 2001. A few weeks later, in January 2002, it abandoned its fixed exchange rate (the peso had been pegged one-to-one with the dollar). The immediate result was a worsening of the financial crisis and a collapse of the banking system. Argentina lost about 5 percent of its GDP in the first quarter of 2002.
However, the paper underlines, the decline was just for one quarter; over the next six years the economy would grow by 63 percent, and in the nine years since the default it has grown by more than 90 percent. Within three years, in the first quarter of 2005, Argentina had passed up its pre-crisis level of GDP. By 2007, it had passed up trend level - i.e. the level of GDP that it would have if it had avoided recession altogether and continued to grow at its average historical growth rate.
"There is no doubt at this point that Argentina made the right move in defaulting on its foreign debt and exiting from its pegged exchange rate, rather than continuing its prior policy of internal devaluation. Yet most commentators insist that a similar move would be a disaster for Greece. It is worth examining why this might or might not be true."
According to the authors, the most common argument is that Argentina recovered by means of a "commodities boom," based mainly on soy exports. "But this is not true," say the authors.
In real terms, exports contributed just 12 percent of Argentina's growth in the expansion of 2002-2008. And only about half of these exports were commodities. And in terms of demand, net exports had a negative real contribution after the first six months of the recovery.
During the first six months, net exports did contribute very significantly to aggregate demand; but even in this brief but important period, most of the new demand came from reduced imports, as local production rapidly replaced imported goods that were made more expensive by the devaluation. The main drivers of real growth during Argentina's recovery were domestic consumption and investment.
Of course, the paper notes, exports did contribute to Argentina's recovery after the devaluation in other ways.
One of the most important contributions was to provide the necessary foreign exchange to cover important imports. This is the primary constraint for a country that does not have its own "hard" currency, e.g. the US dollar. A country can pay its internal bills in its own currency, but it must have enough foreign exchange to avoid a balance of payments crisis. And a tax on the windfall profits of exporters was also important in terms of government revenue during the first part of the expansion.
But exports would also play a similar role in a Greek recovery. In fact, Greek exports of goods and services, including tourism, are about twice as high as a percentage of GDP as they were in Argentina at the time of its default/devaluation. And as in Argentina, these exports would increase in importance relative to the economy with the devaluation - not just because they would be cheaper to the world, but also because every euro or dollar earned from exports would buy more internally.
The common myth that Greece would not benefit from a devaluation as much as Argentina did, "because it has nothing to export," is wrong on both counts: Greece exports much more relative to its economy than Argentina did, and Argentina's recovery was not an export-driven recovery, the paper stresses.
There were a number of policies that were important to Argentina's recovery, but the main thing was that Argentina was freed from an unsustainable debt burden, and perhaps even more importantly, it was freed from the pro-cyclical policies that were making its recovery impossible, and therefore it was able to adopt pro-growth macroeconomic policies.
"It was these policy changes - which Greece would be able to adopt if it left the eurozone and defaulted on its foreign debt - that made the difference between endless recession/stagnation and a remarkable economic recovery."
In some ways Greece is much better situated than Argentina was to recover from the immediate crisis that would follow a default/devaluation. The majority of its sovereign debt is held by foreign institutions, which would reduce the impact of a default on the domestic financial system. Most of its debt is currently covered by domestic law, which might limit the options that creditors would have in taking legal action against the government.
Also, should the European authorities decide to try to punish Greece for its default/exit, Greece has many more potential sources of foreign exchange and investment than Argentina had in 2002. Argentina had nowhere to turn for loans during the first few years. Today, there are many countries with large stocks of reserves that might be willing to invest in Greece once its growth prospects are revived, regardless of any creditors' desire for punishment.
Argentina was cut off from international borrowing after its default. But it was even worse than that: the biggest official lenders, led by the IMF, drained a net $4 billion, or four percent of Argentina's GDP, out of the economy in 2002. Most economists and almost all of the business press predicted that Argentina was in for a long nightmare following its default/devaluation.
The paper says that the IMF put a lot of pressure on Argentina to pay more to the foreign creditors, and to accept a number of economic policies that the Argentine government believed would cut short its recovery. When Argentina refused to give in, and technically defaulted to the IMF in September 2003 rather than accept its conditions, there was a great fear that the country would be cut off even from trade credits - since the IMF supposedly had the power to do that. No middle-income country, or non-failed-state, had ever defaulted to the IMF. But when Argentina defaulted to the Fund in 2003, the IMF quickly backed down and rolled over the country's debt.
The authors say that this part of the story is important because it shows that efforts by even the most powerful creditors to punish defaults are not likely to be successful. In recent history at least, some defaulting countries have done reasonably well or even remarkably well, as in the cases of Argentina in 2001, Russia in 1998, or Ecuador in 2008.
Indeed, a common theme in the recent empirical literature on sovereign defaults is the failure to identify any statistically significant costs associated with default episodes. And Greece is already at the point, given the size of the anticipated write-down that is already in the works, and the bleak prospects going forward, that it will be a long time before it can even borrow on private markets. At this point its credit might return sooner if the government were able to wipe more debt off the books and return to growth.
On the negative side, the paper finds that the biggest obstacle that some have pointed out would be the fact that Greece no longer has its own currency. It would have to re-introduce the drachma. While this poses some potentially serious logistical problems, it is difficult to see that, by itself, this would make Greece different from all other countries that were faced with otherwise similar situations.
"A default/exit option for Greece would be a difficult decision, and of course it is fraught with risks. A lot would depend on how skilfully and quickly the authorities could move from the financial crisis that would ensue, to economic recovery. As noted above, it took just one quarter for the economy to resume growth in Argentina after the default/devaluation."
In the case of Greece, there is no way to know in advance how severe the financial crisis, and associated loss of output and employment, would be if the government were to decide to default and exit from the euro. And that is what makes this decision difficult for the government or any political party: on the other side of the equation, it is not known when the Greek economy will begin to recover under the current programme.
So, although the current programme has failed miserably and can be expected to continue to fail in the foreseeable future, there is considerable uncertainty regarding the effects of either choice. And for political leaders, it may be easier to accept the troika's programme as though - as the European authorities and most of the media frame it - there is no choice.
But, the idea that default/exit would be a catastrophe on the order of a Great Depression is false, says the paper.
The Great Depression was not the result of any one-time event; it was a long series of bad policy decisions over years - in some ways similar to the path of "internal devaluation" that the European authorities have currently laid out for Greece. A default/exit would likely bring on a financial crisis, but it would not by itself cause a Great Depression.
"Given the prognosis for Greece under the current program, and the probability that it will be plagued with recurrent crises and could even end in a chaotic default, a planned default/exit option could very well be the more prudent choice. It should be taken seriously as an alternative," the paper concludes.