Sunday, April 11, 2010

Europe’s bazooka is not enough

Back in August 2008, Hank Paulson, then US Treasury Secretary, went to Congress to request the mandate for a potential financial backstop of Fannie Mae and Freddie Mac, in the event of a loss in market confidence.

Faced with the Congress’ inherent aversion to an explicit government guarantee on the two companies, Mr. Paulson’s argument was raw, yet forceful:

"If you have a bazooka in your pocket and people know it, you probably won't have to use it."

We all know how this ended. Less than two months later, the US government was forced to put both companies into “conservatorship”, as markets decided to test Hank’s resolve to put his powerful weapon to use.

Europe’s EUR30bn financial package to Greece is the new bazooka on the block. Even the Greek Prime Minister himself, George Papandreou, seemed keen on recycling the analogy:

“The gun is now loaded” he said to a Greek newspaper, perhaps unaware of the fate of its US precedent.

As it happens, the European backstop alone does not provide a permanent solution. This is because it continues to treat the Greek crisis as a liquidity problem, when many in the markets believe it’s a solvency one. A permanent solution *has* to involve an IMF program, with a clear and feasible framework for swift debt reduction.

So what would be the elements of an effective Fund program?

The program should have two primary objectives: First, to arrest an impending liquidity crisis by restoring market confidence in Greece’s ability to service its debt; and second, to safeguard the long-term viability of the Greek economy within the context of the euro. The latter would have to involve, inter alia, substantial fiscal tightening to foster price reductions and increase competitiveness.

When it comes to the first objective, the Europe’s EUR30bn package is in theory sufficient to address a potential liquidity crisis, given that it exceeds Greece’s obligations in the short-run. However, it is not enough to restore market confidence in the country’s ability to service its debt, now and in the future. This is because, by some calculations, Greece’s debt is currently not on a sustainable path, unless its fiscal effort goes beyond what the Finance Ministry has pledged under the stability and growth program it submitted to the EU.

One reason is that the low interest rates assumed in the fiscal plan may not materialize for some time. Another reason is that, even with low interest rates, the current plan does not envisage a reduction in the debt/GDP from current levels until after 2013: Instead, the debt is forecast to rise until 2011, and then fall slowly from 2012 onward. This may be unacceptable to investors looking for tangible evidence of a prompt fiscal correction

The issue of debt sustainability is also a legal one: Under the Fund’s lending guidelines, large loans (or, in Fund jargon, “exceptional access”) can only be provided if IMF economists can offer explicit assurances to the Fund’s board that a country’s debt level is on a sustainable path.

It is unclear that Fund economists can provide such assurances at this juncture, without either of the following two routes: One involving tougher, frontloaded and visible fiscal measures that go beyond Greece's current commitments, aimed at restoring confidence in the country's ability to control its debt; or another involving upfront debt restructuring.

In my view, the latter is not a viable alternative for Greece. First, although some two thirds of Greece’s debt is held by foreigners, the institutions with the largest exposure (as a percent of total portfolio) are Greek banks. Restructuring would bring about large losses for the banks, potentially causing bank runs, financial instability and a halt of credit. The consequences of growth would be disastrous.

Second, in the context of the monetary union, the only way to restore Greece’s competitiveness is by forcing a reduction in its prices vs. its trading partners (ie a real depreciation). A tighter fiscal policy that includes wage cuts is instrumental for making this happen, and will have to be part of an IMF program—debt restructuring or not.

Importantly, a tougher fiscal adjustment might look daunting on paper but is not impossible: Greece can achieve a great deal with determined steps to fight tax avoidance, the streamlining of an overbloated and inefficient public sector and penalties to those responsible for the massive expenditure “overruns” (a politically correct term for “money in the pockets of favored individuals”). The point of these measures goes beyond fiscal discipline: They are fundamental in fostering a transparent and rules-based environment for doing business.

As Rahm Emanuel said back in February 2009, “you never want s serious crisis to go to waste.” Greece’s crisis should not go to waste; it’s a wake up call that economic growth cannot be grounded on consumption funded by (what was thought to be) free money. The IMF is a necessary partner in this phase of transition.


Leigh Caldwell said...

I'm not quite convinced by this:

the only way to restore Greece’s competitiveness is by forcing a reduction in its prices vs. its trading partners (ie a real depreciation). A tighter fiscal policy that includes wage cuts...

Tighter fiscal policy yes, but I've not been able to find any evidence that Greek wages are uncompetitive. Details here:

I'd be interested in your thoughts.

Anonymous said...

typo: I believe in the fourth from last paragraph you meant to write: "The consequences for growth" not "The consequences of growth".

Since I have never commented before, I might as well say that I have really enjoyed your thinking/blog over the past year or so.

Chevelle said...

Leigh, thank you for the link. The point I’m making here is about the overall public sector wage bill (i.e. both wages and number of employees). Greece’s public sector wage bill as a % of GDP has been rising steadily, increasing by 2% of GDP since the country entered the eurozone (based on OECD data). While the levels may not be as high by European standards, the steady rise in the public sector as an employer of first resort is detrimental for the country’s productivity—esp. given how inefficient and corrupt the public sector has been.

More broadly, I agree that Greece’s competitiveness problem is more of a product-price problem than a wage-level problem (there are also tons of structural issues that need addressing but here I focus on prices). Since joining the euro, the country’s loss in product-price competitiveness has been second only to Ireland within the EU. Rising unit labor costs have only been part of the reason; but credit-financed demand has been another big component.

What I do disagree with is that the relative rise in Greece’s prices (and, partly, wages) is not a big deal and was the natural corollary of Greece’s faster growth. The problem with this argument is as follows: While Greek value-added (ie GDP) per unit of labor has risen faster than many of its European partners in recent years, this should not necessarily be confused with faster labor productivity. The reason is that the capital input in the production process increased as well, because credit (the cost of capital) became cheap—artificially cheap. Indeed, the growth rates witnessed in recent years will not be repeated, since the cost of capital will not fall for a while. Which means, labor productivity in the “value-added-per-unit-of-labor” sense will likely fall, potentially requiring a correction in real wages.