The past, present and future of the Greek debt crisis

For a decade, until mid-2012, Josef Ackermann was the CEO at Deutsche Bank. It was a position that earned him the nickname “shadow chancellor” of Germany and allowed him to play a decisive role during the European banking crisis and then in the eurozone’s debt crisis.

Ackermann often advised German Chancellor Angela Merkel and, as also the International Institute of Finance (IIF) chairman, was one of the key players in the tense negotiations with eurozone leaders over the restructuring of Greek debt in October 2011. During the European Union leaders’ summit at the time it was Ackermann, with a 3 a.m. phone call from Moscow, that gave the final approval on behalf of the banks for the haircut to take place.

It is interesting, therefore, to assess the Swiss banker’s take on how the Greek crisis evolved, why a debt restructuring did not take place at the beginning of 2010, as the International Monetary Fund wanted and before Greece signed its first bailout agreement.

As for Greece’s future, Ackermann recognizes the significant progress that has been made but warns that the difficulties have not yet passed.

When did you first realize that Greece wouldn’t be able to honor its debt servicing obligations and was heading for bankruptcy? Was it in the summer of 2007 or later?

Greece did not show up on our radar screens until the second half of 2009 – and even then we did not know it was in danger of going bankrupt. Sovereign bond spreads did not start to materially move until early 2010.

As Deutsche Bank’s CEO you paid a visit to then Greek Prime Minister George Papandreou in late February 2010, just two months before Greece officially asked to be bailed out by its eurozone partners. What did you discuss with him back then?

We discussed a plan to help Greece gain time to start economic reforms, bring its house in order and prevent the loss of trust it was facing on the financial markets. Unfortunately our plan did not get the necessary support of the German government, which was afraid of public opinion and not ready to bail out Greece after it had just bailed out weak banks with billions of taxpayers’ money. The plan would not have completely averted the debt crisis, for sure, but it could well have made it less severe.

What was the nominal value of Greek government bonds Deutsche Bank had in its portfolio in January 2010, and what was their nominal value in March 2012, just before the Greek PSI? Did DB respect a call by eurozone finance ministers not to sell their Greek government bonds?

As a matter of principle I do not comment on Deutsche Bank affairs after leaving office. I hope you understand, but you have to ask the bank those questions.

As a banker, you must have been very happy back in early 2010 when the European Council effectively decided to transfer the burden of the Greek debt from the shoulders of private investors to the shoulders of European taxpayers. But was it fair for the European taxpayers?

To avoid moral hazard, creditors should take full responsibility for their investments at all times as a matter of principle. But in the case of Greece’s sovereign debt you have to keep in mind that back then we did not have any rules for sovereign defaults within the European Monetary Union, nor, even more importantly, any mechanisms to prevent spillovers from such a default to other countries. In addition, at the time we did not have a process to deal with potential second-round failures of banks and other financial institutions like insurance companies that were large holders of Greek debt. We were utterly unprepared for the possibility of a sovereign default within EMU – in fact, euro-area sovereign debt had been sold all over the world as a safe investment. We all know what happened when this belief was shattered at the Deauville summit, where France and Germany, to everybody’s surprise, declared sovereign default a possibility. To this day sovereign debt in Europe has never fully recovered from this event. So to sum up my answer, there was no better alternative at the time than to risk taxpayers’ money to solve the crisis. We had to choose the lesser evil.

The Greek state had been borrowing recklessly in the 30 years before the crisis broke, and especially after 2000. But wherever there is a reckless borrower there must be also an equally reckless creditor. Shouldn’t both sides in a loan agreement – the creditor and the borrower – share responsibility for it? Shouldn’t banks pay the price for reckless lending?

You’re right: for every reckless borrower there is a stupid or greedy investor. To this day I keep wondering how investors came to collectively bid down Greek bond prices to a few basis-points over German Bunds to end up owning 350 billion euros of Greek debt? The search for yield and wrong regulatory incentives, such as the zero risk weighting, can explain only part of it. So, yes, investor discipline is as important as borrower discipline. And if investors lack that discipline they have to pay a price as the PSI in the case of Greece shows.

With hindsight, wouldn’t it have been better for European taxpayers if the Greek PSI had taken place before the burden was transferred to their shoulders? Was the Greek PSI too little too late?

In principle, I very much agree with you: Dragging your feet on debt restructuring once it has become inevitable only pushes up the final bill. But, as I explained earlier, a Greek default and debt restructuring wasn’t a realistic option in 2010. And in the end private investors forgave around three-quarters of their investment all in all. Certainly, the agreement could have come some months earlier but I wouldn’t call it too little too late.

Greece’s gross national debt stands at 176 percent of GDP today. Do you think that it is sustainable? Is a new haircut needed?

It goes without saying that this figure has to come down significantly. According to the IMF Greece can reach debt sustainability on the condition of strict budget discipline and a meticulous execution of the commonly agreed adjustment program. As most debt is held by the public sector now, we have bought the necessary time for this program. It is key to concentrate on fully implementing it rather than to hope for another debt restructuring. Making good on its commitments is the best way for Greece to restore investor confidence, regain market access and ensure debt sustainability.

One can see that the eurozone is starting to focus more on the ability of a country (namely Greece) to service its debt, rather than on the nominal value of its debt as a percentage of GDP, as European Stability Mechanism (ESM) head Klaus Regling said in an interview with the Wall Street Journal in September last year. Do you agree with that approach?

I do not see anything new here. There is no such thing as a maximum debt level: Any level of debt is sustainable as long as there are investors willing to finance it – which is why you find solvent countries that have a debt level of 220 percent of GDP like Japan and countries that default with a debt-to-GDP ratio of less than 60 percent, as the Dominican Republic did in 2003/4. The purpose of any debt restructuring has always been to reach the point where investors are again willing to finance a deficit that appears sustainable given the debt level, interest rate and forecast for the sustainable post-reform growth of GDP.

Is a new reprofiling of the Greek national debt enough to make it sustainable or serviceable? What should be the main elements of such an agreement specifically?

Debt levels for Greece and refinancing needs likewise are expected to peak this year at 23 percent of GDP and to decline quickly to around 6 percent of GDP by 2022 as a result of the maturity profile. Based on the current debt profile, gross financing needs will rise again thereafter. But, as I said before, the key to debt sustainability for Greece is continued political commitment to achieve primary budget surpluses of around 4 percent.

Greece has implemented a very ambitious economic adjustment program since 2010. Which would you say were the program’s most important achievements and which were its biggest design flaws?

Greece’s biggest success so far is its fiscal adjustment, not just in the headline deficit figures but in the structural deficit. Equally impressive is the external adjustment, achieving a current account surplus at the end of 2013. As to possible flaws in the adjustment program, I find it hard to identify any significant flaws in the design of the program. If anything, we all underestimated the drag from the simultaneous fiscal retrenchment in many EU countries. In hindsight that would probably have called for somewhat longer adjustment paths. The crux of the matter lies not in design, but in implementation. Specifically, the country’s privatization program has been a major disappointment so far. Similarly, progress on productivity-enhancing reforms in the product, services and labor markets have been unsatisfactory and there is even a risk of a rollback here. I would strongly recommend not to retreat here, but rather to form a national welfare alliance between the state and the private sector to jointly restructure the Greek economy.

Since 2009 the Greek fiscal deficit has been reduced from 15.6 percent of GDP to under 3 percent in 2014. Total compensation of employees was reduced cumulatively by 34.9 percent between 2010 and 2013, and unemployment skyrocketed to 27 percent in Q1 2014 and 26.5 percent in Q2 2014. Wouldn’t you agree that Greece urgently needs a respite?

I am fully aware of the hardships the Greek people have to endure. But it would be wrong not to be honest with them: The return of the country to a sustainable debt trajectory is not yet assured and the still-high debt levels will continue to make Greece vulnerable to a change in investor sentiment. No doubt political commitment to reform will be tested given the lack of scope for significant measures to soften the adjustment burden. Hence, no false promises should be made: The hard times are not behind the Greek people just yet, but many things have been moving in the right direction. This momentum has to be sustained to achieve further progress as quickly as possible to come to a point where the light at the end of the tunnel can be seen by everyone. To ascertain the necessary collective political will it is of the utmost importance to enhance the effectiveness of revenue administration, reduce tax evasion and improve debt collection in order to prevent parts of society from shirking their contribution to reform.

The eurozone’s GDP stagnated in Q2 2014 and inflation in August stood just at 0.4 percent when the target is 2 percent. How many years of stagnation can the eurozone members endure before they revolt?

One has to put the weak Q2 figures into perspective: They partly reflect a payback on the strong Q1. In addition, geopolitical concerns are weighing on Europe’s growth prospects. The present recovery is feeble, no doubt. But this does not come as a surprise: We know from history that balance sheet recessions – and this is what we have in Europe – are usually deeper and it takes longer to overcome them. Political commitment to reform also plays a role: Where governments have been resolute on reform – e.g. in the Baltics and Ireland – recessions have been brutal but short, as business and consumers regained confidence when the economy bottomed out. In contrast, where governments have dragged their feet on reform, recovery has been weak.

Is the eurozone facing secular stagnation?

Europe displays a number of features that can cause a secular stagnation: The labor force is stagnating and so is productivity growth; investment rates have declined, the costs of financial intermediation have been pushed up by financial regulation, real interest rates remain elevated due to low inflation, and consumption is suppressed by widening income inequality. But none of this is immune to change by political action. For instance there is ample scope in most European countries to increase the labor force by raising the participation rates of female and older workers. It is up to us whether Europe will experience secular stagnation or not.

Italy has lost 7 percent of its GDP since 2007 and is facing the third period of recession. How many more quarters with negative growth, or stagnation and extremely low growth rates at best, can Italy endure?

That is ultimately a political not an economic question. The new government in Rome is advocating reforms. It is crucially important that it carries them out successfully because the fate of EMU will be decided in Italy and France.

Was Milton Friedman right when he warned European leaders that “monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity”?

Well, the jury is still out, and I am more optimistic than Professor Friedman. As the sovereign debt crisis has shown, the challenges they faced have spurred EMU member states to enhance their cooperation and to deepen political union. The creation of a banking union is perhaps the best example of this.

Do you agree that the eurozone’s response to the debt crisis was and still is asymmetric? Debtor countries implemented harsh austerity measures, but creditor countries didn’t respond with expansionary fiscal policy that would counterbalance austerity and help achieve the desired rebalancing of the eurozone economy. Should so-called “core” countries, Germany among them, have followed a more expansionary fiscal policy. Should they do it now?

It is a fact of life that the burden of adjustment lies mainly with the debtors and not the creditors. And rightly so. Having said that, the EU has actually achieved quite a bit on getting a better balance: In the Commission’s assessment of economic policies, excessive surpluses are chided as an economic imbalance to be rectified. More importantly, EMU surplus countries do their share of adjustment: Unit labor costs in Germany rise faster than in the crisis countries and its surplus vis-a-vis those countries has dropped markedly: Compared to 2007, Germany’s current account surplus with the GIIPS countries dropped by almost 70 percent – whereas its overall surplus actually rose 2 percent in the same period. Besides, it would be of small importance for Greece if Germany had a higher growth rate: An increase of German real GDP by 1 percentage point would raise its good imports from Greece by merely 40 million euros, or 0.02 percent of Greek GDP – reflecting the low income elasticity of imports from Greece due to the fact that Greek exports to Germany are skewed toward food and beverages, which account for 30 percent of total exports. Even if you included tourism, the growth impulse for Greece would barely reach 0.1 percent of GDP.

Why is investment in Germany so low? It stands at just 17 percent of GDP in 2013, just 3 percent more than investment in almost bankrupt Greece.

Apart from a short period after unification, Germany’s investment rate has been on a declining trend since the 1960s – but that has been the case in most Western countries. More importantly, one needs to differentiate: Private sector investment in machinery and equipment has not been out of line with fundamentals and there has been no reduction in the capital stock. Given that wage growth has been so subdued in Germany for such an extended period of time, firms have also substituted capital with labor. If R&D investment is included, German companies’ investment is actually on a par with their international peers. As regards net investment in housing, which accounts for almost 60 percent of total investment, this too has declined rather steadily over the past decades – but this is quite natural considering a shrinking population. If anything, it is fortunate that Germany has not suffered from the sort of housing bubble that other parts of EMU experienced.

Public sector investment, however, is not sufficient to maintain the existing capital stock, let alone to expand or modernize it. The reason is that the federal level and the German federal states are under pressure to consolidate their budgets in the runup to the constitutional debt brake – and politically, it has always been easier to cut investment rather than current expenditures. Clearly, the political system has delivered the wrong priorities here.

Do you support the ECB’s decision to use all tools that fall within its mandate in order to hit the 2 percent inflation target?

The ECB is right (as was the Fed) to fight the incipient risk of deflation. A period of deleveraging after a bubble constitutes fertile ground for deflation, as there is surplus capacity, high unemployment and a need for public, household and corporate sector savings – a dangerous combination of excess supply and depressed demand, in other words. Once deflation has taken hold, it is difficult to erase it. So central banks are right to fight it from the outset within their capacity. But there is only so much monetary policy can do – structural reforms must complement it.

Should the ECB resort to full-blown American-style quantitive easing (QE) in case all other measures fail? The Bundesbank seems to strongly disagree with this prospect.

Let us see whether the measures already announced by the ECB work before we speculate on eventual new measures. The latest round of measures, viz the targeted long-term refinancing operations (LTROs), had a limited effect only. There seem to be diminishing returns to unconventional monetary policy, too. In any case, it will be almost impossible for the ECB to engage in the equivalent of QE as there is no single sovereign issuer in the euro area. Given this, it is a political no-go for the ECB to buy sovereign debt on a large scale.

Is there a threat of deflation in the eurozone?

There is a risk of excessively low inflation for a prolonged period and given the fragility of the recovery there is a certain risk that in parts of the euro area this could bring the price trend dangerously close to deflation. But for the euro area as a whole I don’t see the risk of deflation.

What is your view on the so-called banking union?

The banking union is arguably the most important project of EU integration in the last two decades. It fills a huge gap left at the time when the single market for financial services and EMU were designed, respectively: A single-currency area and a single financial market need a supranational supervisory system, including a resolution scheme, to ensure financial stability and to avoid the risk of market fragmentation. The overall design of the banking union is good, but the resolution mechanism looks too cumbersome. I don’t think that it would allow authorities to act with the necessary flexibility. I also wish that member states had been more courageous and agreed on a truly pan-European resolution scheme rather than the hotchpotch of European and national elements that we have now: I hope that this scheme will evolve toward a more unified design over time.

One of the eurozone leaders’ stated goals while deciding to form a banking union was to break the so-called vicious cycle between weak states and weak banks. How could that be achieved without a common eurozone backstop for banks? The agreed backstop will be fully common in 10 years and its size will be only 55 billion euros. Is it enough?

Actually, I don’t believe that the common backstop is the main instrument for breaking that vicious cycle. You rather need a geographic diversification of banks’ asset and funding sources for that as well as an end to the zero risk weighting for sovereign bonds. In any case, the principle established by the SRM, viz that in case of banking failures bail-ins will take precedence over bailouts, will be the most important measure to ensure that in future weak banks will no longer drag governments down with them.

Why was the third pillar of the banking union, namely deposit insurance, dropped? How credible is the eurozone without the Central Bank guaranteeing deposits as is the case in the US and elsewhere?

I agree that pan-European deposit insurance would, in principle, be an integral part of a comprehensive EU banking union. However, it is also the least important one, as long as the other elements that have now been agreed upon work satisfactorily. It is important that we have uniform minimum standards for deposit guarantee schemes (DGS) at the national level and credible financing arrangements for these national schemes. Clearly, the political commitment taken by all member states collectively that retail deposits protected by DGS will not be bailed in in future bank resolutions sends a powerful and credible message here.