Not cutting Greek debt is aggravating the problem
On the face of things, the troika—the IMF, the European Central Bank and the European Commission—are justified in not agreeing to the demands of Greek’s new government to end the austerity policies since it will spur the demand for similar debt write-downs and expanded government spending from other countries. The problem with this view, as well as the moral one that countries that have lived beyond their means must pay their dues, is that it gets Europe nowhere and it ignores the real problem of the troika selling Greece a fiction. A fiction that, within two years of the austerity measures, Greece would be on its way to recovery and, after reaching 15% by 2012, unemployment would fall dramatically. The reality today is that unemployment is as high as 28% and youth unemployment is as high as 60%.
And none of this, though Germany is derisive of ClubMed countries like Greece, is due to these countries not slashing expenditure—Martin Wolf of the Financial Times estimates Greek spending on goods and services has fallen by at least 40% since the crisis. And, more important, there is no sign of a quick recovery despite the fact that Greece has been running a primary surplus for more than a year now—current plans require the surplus to reach 4.5% of GDP in 2016, a situation that will cause a revolution given current unemployment levels. The fiction is something even the IMF’s research director Olivier Blanchard admitted when he wrote a paper, in January 2013, saying the IMF had got the fiscal multipliers—percentage reduction in output for every unit of cut in spending—wrong by three times. While the IMF had estimated a multiplier of 0.5—every 100 bps of cut in government spending would cut GDP by 50 bps—the multiplier was more likely to be in the 0.9-1.7 range. In such a ‘liquidity trap’ situation, reduction in government spending will, as in the case of Greece, only make things worse since, as GDP shrinks, the critical debt-to-GDP number keeps rising.
To be sure, Greece doesn’t want to get out of the euro given the run that this will cause on its banks immediately; the flip side is Germany and others can’t afford to have Greece walk out either since this risks the possibility of contagion once markets start reassessing other weak economies—also, were Greece to exit the euro, and pay back European banks in drachmas, that would have a big impact on European banks who lent to Greece without even assessing its credit worthiness. Given that Greece needs to pay back 3.5 billion euro of ECB bonds by July and another 3.32 billion euro by August, it is clear it will default if the next tranche of bailout funds is not made available soon. Which is why it would be wise for the new Greek government to ask for a ‘technical extension’ of the current bailout—it ends on February 28—for another 6 months during which all parties need to soberly reassess their positions. The huge Greek bailout of 227 billion euro from the IMF and the eurozone, as Wolf points out, went largely to avoid the write-down of bad loans to the Greek government/banks—bailing out lenders directly, he says, “would have been too embarrassing”. Asking Greece to pay a cost for its profligacy is essential, but the price has be something it can bear.