Steps needed to arrest dynamics of debt, regain credibility despite execution risks

As the expected, fatigue resulting from the implementation of economic reforms and fiscal austerity becomes more evident and the recession gets deeper, prompting more and more market participants and others to call for the restructuring of Greek public debt, it is becoming evident that the country has to come up with a comprehensive solution to arrest the dynamics of the debt and regain market credibility.

Public sector roots

It is known that debt problems have different origins but most of them are caused by public sector excesses. Unlike Ireland and Spain, where the debt problem originated primarily in the private sector – namely the banking sector – Greece?s debt problem has its roots in the public sector.

This does not mean the country is not facing other problems. Greece has also to cope with an international competitiveness problem.

This is partly evident in the large current account deficit estimated around 10 percent of gross domestic product in 2010 and to some extent explained by input and output market inefficiencies. In addition, fast nominal wage growth, which is more than justified by productivity gains in the non-tradeable sectors such as services and construction, spilled over to the tradeable sectors, contributing to the loss of international competitiveness.

Greece?s economic policy program endorsed by the European Commission, the International Monetary Fund and the European Central Bank has tried to deal with the erosion of international competitiveness by setting out a list of structural reforms such as removing barriers to enter certain professions and streamlining the greater public sector.

As expected, many interest groups have objected to most of these reforms which are supposed to be implemented in a relatively short period of time and this has not escaped the attention of cabinet members who take political cost very seriously. It should be noted however that a far-reaching reform of the social security system has already been voted on in Parliament.

Assuming that the new laws become effective, some of these reforms will have a beneficial effect on the Greek economy and public finances in the medium to long term.

However, in the long run we are all dead, as economist John Maynard Keynes said once.

Major mistake

We have argued before that one of the major mistakes made by the troika and the government in addressing the Greek public debt crisis is they have failed to recognize the possibility of insolvency and addressed it as if it were a liquidity crisis.

Reducing public debt by producing large primary budget surpluses at 6.0 percent of GDP or over for more than a decade is one way to go but necessitates a substantial fiscal tightening which becomes even tighter if IMF conditionality applies.

A tight fiscal policy coming at a time of weak domestic demand and private sector deleveraging is certain to hurt GDP even more since strong exports can?t do much to help an economy with a small external sector and a reduction in unit labor costs takes time to help restore international competitiveness.

The ensuing decrease in GDP hinders the reduction in the public debt, creating a vicious cycle that hurts economic growth and makes it difficult to bear both socially and politically.

Greece has been going though this cycle, betting that the strict implementation of the economic policy program will reduce public debt over time and help the country regain its credibility with international investors. Early this year it became evident that this form of debt reduction was not enough to convince the markets and some 50 billion euros? worth of privatizations and real estate asset sales were added to the package.

Market distrust

However, by keeping the Greek bond yield spreads and credit default swap spreads at prohibitively high levels, the market showed its distrust.

So one has to ask what it will take to satisfy the markets to lend to Greece at affordable interest rates.

Obviously, the implementation of structural reforms sought by the economic policy program will help, although the fruits will become apparent a few years from now.

Unfortunately, the economic program sought to tackle the country?s large budget deficit by putting more or equal weight on raising tax revenues than cutting spending. This is despite the fact that Greek primary expenditure has grown by more than 80 percent since 2004.

Asset sales will also help but it will not help the market to change its mind as the public debt-to-GDP ratio heads toward 160 percent.

Comprehensive solution

The comprehensive solution should therefore include all of the above and a milder dose of fiscal austerity, meaning additional austerity measures stemming from conditionality should not be taken. However, most importantly, the comprehensive solution should remove the debt overhang from the Greek economy to help economic agents price the risks of investing more accurately and let liquidity flow more easily to banks and the economy.

Whether this takes the form of a generous debt reduction via rescheduling or something else such as the exchange of old Greek bonds with new longer ones with lower coupons guaranteed by the European Financial Stability Fund is up to the planners.

Undoubtedly, there are serious execution risks involved in removing the debt overhang from the economy, including a run on bank funds, and therefore it has to be done very carefully.

But unless this is done, Greece is in danger of facing a protracted period of stagnation with serious social and political consequences and no market access for many years. This is not in anybody?s interest.