After the drama of the on-again, off-again referendum, and the formation of a new national government, attention in the ongoing European debt crisis has turned from Greece to Italy, where the downfall of Silvio Berlusconi appears imminent. This shift of attention is unsurprising, but unfortunate, since we are in danger of learning the wrong lessons from the Greek crisis.
Here are five myths about the Greek crisis that must be dispatched if the broader debt crisis affecting both Europe and the United States is ever to be resolved.
MYTH 1: Greece cannot solve its problems without a formal default
A decade ago, this would have been a distinction without a difference. Creditors only accept a voluntary haircut if the alternative is an involuntary one. But with the explosion of markets in Credit Default Swaps, tens of billions of dollars can turn on the difference between an explicit default, which triggers payments on these swaps, and a voluntary restructuring, which does not. In theory, CDS markets are supposed to spread the risk associated with defaults, and thereby make financial markets operate more smoothly.
MYTH 2: The rescue package will solve nothing because it won’t significantly reduce Greek debt.
In formal terms this is true. The voluntary restructuring only applies to bank debts - around … billion of the total. But it is obvious that, sooner or later, the same forgiveness must be extended to debt held by the European Central Bank and the IMF. Fortunately, this is not really a problem, at least for the ECB, which in any case needs to greatly expand the supply of euros through a US-style policy of quantitative easing. If debt forgiveness is combined with expedients such as asset sales, Greek public debt can be reduced to levels of around 60 per cent of national income.
Debts of this magnitude can be sustained if the economy is growing and government revenues are sufficient to fund current expenditure (excluding capital investments and debt service). The austerity package will come close to achieving the second goal, while the first depends mainly on the adoption of more expansionary policies for Europe as a whole.
MYTH 3: If Greece defaults, it must abandon the euro.
The explosion of Greek public debt in the decade after 1998 rested on an assumption that all euro-denominated government debt was equally good. This permitted Greece to borrow at low rates, even though anyone who was paying attention knew that governments and lenders were colluding to hide deficits and debts far greater than those allowed under the Convergence and Stability Pact. And, indeed the aim of the Pact was to avoid a situation where some eurozone governments engaged in deficit finance, thereby undermining the system as a whole.
As far as Greece is concerned, these aims were clearly not met, and much of the thinking that prevailed during the first decade of the euro has proved to be unsound. But there is no point in crying over spilt milk. A Greek default, or a voluntary restructuring, is now inevitable, but it does not entail a departure from the euro.
This is fortunate, because the option of leaving the euro is exceptionally unappealing. Admittedly, it would permit a rapid devaluation, making exports competitive. Indeed, the capital flight that would precede and accompany an exit from the euro would render a revived drachma or new Greek currency almost valueless, unless and until normal economic conditions could be restored. Even on the unappealing terms.
MYTH 4: The Greek debt crisis is a template for the European debt crisis as a whole.
The standard narrative about the European debt crisis is that it arose because profligate governments took advantage of the low interest rates paid on euro-denominated debt, allowing them to run large deficits which have now mounted up to produce the debt crisis. That narrative is true, with some qualifications, of Greece but much less so for the other countries that have been bailed out. Moreover, it absolves the main culprits, namely financial institutions, financial regulators and central banks, whose policies produced the crisis.
It is true that successive Greek governments used low-cost borrowing as an alternative to fiscal discipline and to any serious attempt to bring tax evasion under control. Even in Greece’s case, however, it is important to observe the active complicity of financial institutions like Goldman Sachs, which helped design artificial transactions to conceal public debt. Even more important were the French and German banks, which were eager to look the other way because it enabled them to record Greek government bonds on their books as risk-free assets, of which they could hold unlimited amounts under the Basel II system of financial regulation.
More importantly, Greece was the exception, not the rule. Most of the other governments that have run into trouble were in fiscal balance, or even surplus, before the crisis. Their problems have arisen from the need to bail out failed financial institutions, and to stimulate national economies driven into recession by the crisis.
The primary culprits here are the banks and their regulators. It is entirely appropriate that they should take a large loss on their Greek loans, and that their shareholders should be wiped out in the recapitalizations that will surely be necessary.
But a large share of the blame should go to the European Central Bank. The ECB has pursued an obsessive focus on its 2 per cent inflation target. Even though it is well known that low inflation conditions are conducive to financial bubbles and busts, the ECB saw no reason to concern itself with the stability of the financial system, traditional the primary concern of central banks.
Having failed to anticipate the crisis, the ECB and its President, Jean-Claude Trichet, sought to forget about it as quickly as possible. Once the immediate emergency was passed, Trichet resisted any monetary expansion and even raised interest rates at the height of the debt crisis. Under its new President, Mario Draghi, the ECB has taken tiny steps away from Trichet’s failed policies (the second of his interest rate hikes has been reversed) but much more remains to be done.
The idea that government fiscal policies have been excessively lax, and that they need the discipline of financial markets and central banks is a travesty. It is the markets and central banks who have failed, and who need to face the consequences.
MYTH 5: Austerity is the answer.
The most dangerous myth of all is that governments can best contribute to economic recovery through policies of austerity, cutting government spending and raising taxation. As well as reducing debt it is claimed, such policies will make room for the private sector to expand. This idea of ‘expansionary austerity’ can be traced to work undertaken in the 1990s by Albert Alesina and various co-authors. Although widely discredited (even by some of his co-authors) these ideas appeal to the wishful thinking of those who want to see themselves as ‘wise men’, the equivalents of the Very Serious People who stand for the conventional wisdom in US policy debates.
In fact, there is overwhelming evidence that the short-term impact of austerity measures is to reduce the rate of economic growth, thereby reducing government revenues and increasing necessary expenditure on unemployment benefits and other welfare measures. As well as worsening the recession, these effects will offset much of the improvement in the budget balance that might have been expected from austerity measures.
In the long run, it is clear that Greece (and to a lesser extent other European countries) needs to improve its budget balance. The experience of the crisis suggests, if anything, that the target of a deficit equal to 3 per cent of national income, and debt equal to 60 per cent of national income were not ambitious enough. To respond adequately to a crisis, governments need the fiscal space created by exercising discipline in good times.
But these are not good times. There is no point fixing long-term budget problems if the short-term result is the collapse of national economies, and possibly of the eurozone as a whole.
Of all the myths coming out of the Greek crisis, austerity is the most dangerous.