Europe faces a critical juncture on Thursday – one that may determine not only whether the euro will survive, but whether the global economy will be once again plunged into turmoil. To an economist what needs to be done is simple and clear: Greece’s debt has to be brought to a sustainable level. That can only be done by lowering the interest rate that Greece pays, lowering its indebtedness, and/or increasing gross domestic product. There are several ways this can be accomplished. But the institutional details are less important than an understanding of what will, and what will not, work.
The strategy of the past 18 months of dealing with Greece’s debt difficulties – the minimal response necessary to deal with the moment – has (predictably) not worked. Nor will more of the same. Official lending (from the International Monetary Fund and the European Union) has seniority over the private sector. The riskiness of new private sector lending is thereby increased, with obvious implications for interest rates. Meanwhile, as official lending replaces private sector lending, the risks associated with past lending is shifted to the public. The pattern, and the disappointment, should be familiar to those who watched IMF/G7 programmes of the past.
Economists may differ on whether the austerity prescription will work – though the evidence from Ireland, Greece, Spain, Latvia, and host of other experiments shows that the ensuing economic downturns reduce tax revenue, so the improvement in the fiscal position is inevitably disappointing – but the market has rendered its verdict: it too is signalling that more of the same will not work. Lowering GDP worsens debt-sustainability (typically measured by the debt to GDP ratio) every bit as much as increasing indebtedness. The speculators have been handed an opportunity, and they have seized it. They make money from volatility. Of this we can be certain: Europe’s response so far has amplified uncertainty concerning the future of the euro. “Contagion” has now spread from the periphery to the centre, namely Spain and Italy.
So too “reprofiling” – changing the timing of payments leaving the level of indebtedness unchanged – simply postpones the day of reckoning. If, as often happens, it is accompanied by higher interest payments, the likelihood of an even worse crisis down the line is enhanced. The reason that Greece and the other crisis countries of the periphery face a liquidity problem is that markets believe, probably correctly, that – without access to better terms and/or a debt writedown – there is a real risk of non-repayment.
The problem facing Europe is not so much economic as political. It is easy to see what should be done. If Europe issues eurobonds – supported by the collective commitment of all the governments – and passes on the low interest to those in need – debts are manageable. Even a 150 per cent debt to GDP ratio can be handled if interest rates are low enough, but if rates are high they cannot be. At 6 per cent it takes a primary surplus of 9 per cent just to service the debt. Europe can access capital at low interest rates; after all, its collective debt to GDP ratio is actually better than that of the US.
Those who, putting aside any sense of European solidarity, worry about creating a “transfer union” should be comforted: at such low interest rates the likelihood of a need for real subsidies is limited. But even if there were some subsidy, Europe could afford it. With a $16,000bn dollar economy, even if Europe had to bear costs commensurate with the size of Greece’s debt, these are minuscule compared to what will be lost if Europe does not come to the assistance of the countries facing trouble.
The current strategy has reached not only its economic, but also its political, limits. In at least some of the countries, citizens have put the EU on notice – not just through protests, but though actions. With free mobility of labour and capital, neither workers nor entrepreneurs can be forced to pay too much for the sins of the past. They can move, and they are moving.
Europe is lucky that in most of the countries in its periphery, there were responsible governments that did not take populist stands. What George Papandreou has done in the past eighteen months has been truly impressive. One could hardly have expected more. That the improvement in Greece’s fiscal position has been less than what was hoped is not because he did not deliver but because the benefits of structural reforms take time to be realised – more time than the political process allows; because austerity seldom works and because Greece’s trading partners’ economies have not done as well as hoped.
In at least one of the countries – and perhaps in the future, in others – there wait in the wings less responsible politicians who would take advantage of widespread views that Europe has not done what it should, while imposing harsh conditions. Rather than shared sacrifice, they are even calling for tax cuts. The IMF may have been able to impose harsh conditions in Asia and Latin America, but Europe has vibrant democracies, with an informed and active citizenry. What was possible there may not be possible here.
There is one more ingredient to a successful response: restoring growth. The current uncertainty has had an especially adverse effect on banks and bank lending. Even well-run small and medium-sized businesses are being starved of funds. Growth tax revenues languish, even if governments do a good job at tax collection. A solidarity fund for stabilisation could, together with the European Investment Bank, make needed investments in the countries in trouble – investments that would more than pay off at the low current interest rates. A small business revolving loan fund could provide money to proven enterprises, to help restart the engines of growth.
Europe’s problems today are not the result of a natural disaster, like those confronting Japan. They are man-made, partly the result of a well-intentioned, but imperfectly-conceived, monetary union. It was hoped that, in spite of the marked differences, if countries only managed their debts, all would work well. Spain and Ireland, which both had surpluses and low debt to GDP ratios before the crisis, showed the fallacy in this logic.
As Europe stands at the precipice, it is time to end brinkmanship and political squabbles. The European Central Bank should realise that a restructuring – even if it entails a “credit event” as determined by some American rating agencies – means that Greek bonds are safer than they were before. If they were acceptable as collateral before, they should be more acceptable after. Put bluntly, to not accept Greek bonds is to end Greece’s membership in the euro, with all the consequences thereto.
The ECB must recognise too that for citizens of many countries, a deal without shared sacrifice of the private sector – meaning debt reduction – is politically unacceptable. But those advocating private sector involvement need to realise that the private sector will be reluctant to take a haircut on old loans, and will refuse to accept less than a risk-adjusted interest rate on new.
The resolution of this crisis is easily within Europe’s grasp. It is not a matter of economics. It is only a matter of political will.
The writer is a recipient of the 2001 Nobel Memorial Prize in economics and University Professor at Columbia University