A European Monetary Fund

Sapir and Schoenmaker at Bruegel have a discussion of what a European version of the IMF might look like and do. Here are my thoughts on the sovereign debt (not banking) side, which I am sure will be regarded once again as radical and will therefore be ignored.

I think some new Eurozone institution is necessary, but not for the reason that most people might think. The idea that the Eurozone might have a common fund that lends to Eurozone countries in fiscal difficulties with associated conditionality, as the IMF does, is a terrible idea. We know it is a terrible idea because of Greece.

Think of the following scenario. A country getting into difficulties is lent some money by the EMF. That sum increases as existing private investors take fright. For whatever reason the ‘recovery plan’ imposed by the EMF goes wrong, and it becomes clear to all neutral observers that the country needs to default on its debts, including those to the EMF. As the EMF loan is regarded as ‘our money’ by a good part of the EZ electorate, this default is resisted and punitive austerity is imposed on the country so that the EMF can get its money back. This does not happen to the IMF because the electorate in any individual country do not think of their loans as ‘their money’, but it is naive to believe that wouldn’t happen with an EMF. It is exactly what happened in Greece, and it is also why moves to a political union are far too premature..

This raises an obvious question: why have an EMF, when we have an IMF? The wrong way of thinking about that question is that the Eurozone needed to supplement the IMF during the last crisis. The last crisis is not a good example because the ECB did not operate OMT until September 2012. The right way to think about the past is what would have happened if OMT had been operating from the start.

The ECB is (rightly) only prepared to operate OMT for a country that is returning its financing to some sustainable level. For some countries that may not be possible, or desirable, without default. That was the case for Greece. For others that will be possible without default, as Ireland and Portugal have shown. You need somebody, or some institution, to decide which category a country finds itself in. But whether default is needed or not, a recovery plan (austerity) has to be put in place to return the public finances to sustainability and once that plan is in place OMT then operates.

Once that happens, I think any lending should be done by the IMF for the reason I have already given [1]. However it may well be that as long as the austerity is sensibly mild and drawn out [2], private sector lending will resume because of OMT.

I think a new institution to do both the job of initially deciding about default and to create the recovery plan would be a good idea. But both decisions have to be kept as far away from politicians as possible. The reason again comes from history: the loans to the government that may require default are likely to be from banks or institutions in other EZ countries. That creates a serious bias towards ‘lend and pretend’, as we saw with Greece. 

How can you achieve such independence in the EMF? In addition, how do you justify giving an institution staff and resources when it hopefully will be hardly ever needed? One answer could be to use the IMF, although at the moment the IMF is not sufficiently independent of EZ politicians. Another is to utilise the network of independent fiscal institutions or fiscal councils that every EZ country now has. If those institutions live up to their name, they should be independent of politicians. In addition, they have exactly the expertise to decide on any default and to put together a recovery plan.

Now the great thing about this set-up is that it allows fiscal autonomy in countries that have not got into fiscal difficulties. Fiscal discipline through the market is restored, because there is a clear default risk (but not the self-fulfilling default risk that operated before OMT). There would be less of a feeling in countries like Germany that they had to worry about fiscal policy in other EZ countries because they will pick up the tab because there will not be any tab to pick up. In that sense the no bail out rule is restored. 

What would the Brussels machinery that currently monitors each EZ country do? Am I proposing to put some Brussels bureaucrats out of a job? Not necessarily. A potential problem with the system I suggest is that fiscal councils will be captured by their governments. Brussels could ensure that the fiscal councils are independent, which would involve checking their assessments and forecasts (or even supplying them with forecasts).

I can predict with almost certainty that some comments will be that I am taking crucial decisions away from democratically elected politicians and giving them to technocrats. We have enough of that in the Eurozone as it is they will say. There are two simple responses. First, in the absence of the Eurozone, governments that were no longer able to borrow would face the technocrats at the IMF. Second, we have tried the democratic route and it has failed spectacularly for reasons that will not go away in a hurry. 

There you have it. A feasible plan to increase sovereignty in the Eurozone and mitigate another Eurozone crisis and avoid another Greece. Now tell me why we have to move to fiscal and political union.

[1] Obviously in that case the IMF would also have to approve the recovery plan.

[2] A short sharp shock will almost inevitably lead to damaging negative feedback on output, perhaps creating another Greece.

Whatever happened to the government debt doom spiral

A number of people, including the occasional economic journalist, are puzzled about why government debt at 90% of GDP seemed to cause our new Chancellor and the markets so little concern when his predecessor saw it as a portent of impending doom. I always argued that this aspect of austerity had a sell by date, so let me try to explain what is going on.

The 90% figure comes from a piece of empirical work which has been thoroughly examined, and found to be highly problematic. (Others have used rather more emphatic language.) Part of the problem is a lack of basic thinking. Why should the markets worry about buying government debt, beyond the normal assessment of relative returns. The answer is that they worry about not getting their money back because the government defaults.

If a government cannot create the currency that it borrows in, then the risk of default is very real. Typically a large amount of debt will periodically be rolled over (new debt sold to replace debt that is due to be paid back). If that debt cannot be rolled over, then the government will probably be forced to default. Knowing that, potential lenders will worry that other potential lenders will not lend, allowing self fulfilling beliefs to cause default even if the public finances are pretty sound.

The situation is completely different for governments that can create the currency that the debt they sell is denominated in. They will never be forced to default, because they can always pay back debt due with created money. That in turn means that lenders do not need to worry about forced defaults, or what other lenders may think, so this kind of self fulfilling default will not happen.

Of course a government can still choose to default. It may do so if the political costs of raising taxes or cutting spending is greater than the cost of defaulting. But for advanced economies there is an easier option if the burden of the public finances gets too much, which is to start monetising debt. That is what Japan may end up doing, and what others may also do if QE turns out to be permanent. But this is a very different type of concern than the threat of default. And it does not, in the current environment, lead to the emergence of large default premiums and market panics.

How can I be so sure? Because with QE we have had actual money creation, and it has not worried the markets at all. It seems hard to tell a story where markets panic today about the possibility of monetisation in the future, but are quite sanguine about actual monetisation today.

So for economies that issue debt in currency they can create, there is no obvious upper limit anywhere near to current debt/GDP ratios when economies are depressed and inflation is low. Japan shows us that, and we must stop treating Japan as some special case that has no lessons for the rest of us. (How often did we hear of their lost decade in the 1990s that it couldn’t happen anywhere else.)

It was good that the IFS suggested Hammond has a look at Labour’s fiscal rule. As I explained in this post, Hammond’s new ‘rule’ is pretty worthless. But one key part of Labour’s rule that keeps being ignored but is crucial in today's environment is the knockout if interest rates hit their zero lower bound. It is for the reasons described above that this knockout is there and is perfectly safe: when interest rate policy fails you can completely and safely forget the deficit and debt and use fiscal policy to ensure the recovery. It is the basic macro lesson of the last 6 years that is fairly well understood among academic economists but still remains to be learnt by most people who talk about these things. Whether senior economists in the UK Treasury need to learn it or just keep quiet about it for other reasons I do not know.

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.

Making the Eurozone work better: sovereign default

Given the current problems in the Eurozone, it is understandable that many non-Eurozone economists remind us that they had doubts from the beginning. That, unfortunately, is not very helpful criticism, except in so far as it tells us how these problems were originally wished away. One lesson from the Greek tragedy is that voters' faith in the Euro project can survive even under tremendous strain. [1] The Euro was always a political project, and the political reasons for it have not gone away. For the governing elite of Europe this is likely to remain the case. So going backwards is not an option.

Yet while the people and the elite both want to keep the Euro, they part company when it comes to moving to a complete fiscal and political union: a United States of Europe. As Philippe Legrain notes, ever since the French and Dutch voted No, voter attitudes to further central control have hardened - and with good reason. If what he describes as the “Monnet method” (use any crisis to increase integration) continues, and as Andrew Watt points out it is continuing in a big way, the threat to the Eurozone could become existential. European policy makers have taken far too many liberties with democracy as it is: they should not take even more. Which is why I tend to get a little impatient with economists and institutions that spend a lot of time designed schemes for further substantial integration.

So the critical issue for now is whether the way the current union is run can be improved? I see three key unresolved areas here: sovereign default, competitiveness imbalances and the ECB. I talked about how to cope better with potential competitiveness imbalances recently. This post is about default.

I agree with Philippe Legrain that we need to have more decentralised fiscal control, and less rules from the centre. As I have noted before, there now exists in the Eurozone a system that is parallel to monitoring from Brussels, based instead on national fiscal councils. Can we design a system around that which negates any need for central control?

One way of making this work would be to deny any support to any EZ government that gets into trouble with the market. When the EZ was set up, its architects worried that market discipline would be too weak for this to work, so centralised controls were also necessary (the Stability and Growth Pact). In one sense they were right: the markets started treating Greek government debt as if it was German debt. But once a crisis happened they were wrong: governments with lower deficits than the UK were regarded as riskier by the markets.

What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT. But you cannot have OMT without conditions. For obvious reasons OMT cannot be a blank cheque to a monetary union member to run ever higher deficits.

So OMT has to be conditional, but who should set the conditions? Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default? At the moment the answer is both the other Eurozone governments and the ECB decide. But Eurozone governments have shown themselves to be hopeless at this task (see actual Greece), partly because they are subject to pressure from creditors. To leave this all to the unelected, unaccountable ECB is just asking for problems, and would represent too great a strain on ECB independence.

Let’s imagine the following. The Italian government at some time in the future finds that interest rates on its debt begin to rise well above average Eurozone levels. We get into a situation where a self-fulfilling default is possible. Should the ECB supply OMT cover to end that possibility or not? What conditions should be imposed on Italy as the price for that cover?

It would be nice if we could write down some simple rules (even complex rules) that could choose between a Greece and an Ireland. Fabian Lindner discusses some possibilities here. The major problem is that a great deal depends on something that embodies a political judgement: just how large will future primary surpluses be? Italy, because of its large debt, is used to running much larger primary surpluses than other countries. How do you judge what the upper limit is?

This is why ‘leaving it to the market’ is so attractive, because you appear to be asking a huge number of people to take a bet on the answer. But that method is flawed, because with rollover risk what they are actually taking a bet on is what they think other market participants think about rollover risk. OMT removes that rollover risk.

So if the market cannot do this, and the ECB and EZ governments should not do this, who is left? Do we set up a new institution of experts to decide and set conditions? (Conditions have to be set, because actions may change after OMT is granted.)

One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF. It is imperfect, with at the moment too much influence from EZ governments on its decisions, but that means reforming the IMF rather than reinventing it. This may happen as a result of the Greek debacle. Philippe Legrain suggests using the IMF in a similar role here, although as a transitional measure while a new EZ institution is set up. However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.

The proposal would work like this. When Italy got into difficulties, it would go to the IMF. No EZ assistance would be allowed before this. The IMF would decide what level of default (if any) was required. The IMF, and not EZ governments, would set any conditionality thought necessary to return deficits to a sustainable level. That would include a path for deficits that the country could reasonably achieve without creating unnecessary unemployment. (If the country was uncompetitive, some unemployment would be inevitable.)

If Italy agreed to those conditions, then OMT would automatically be extended by the ECB. It is quite possible that in those circumstances Italy would regain market access at reasonable rates. If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.

I suspect this scheme would not be attractive to many Eurozone policy makers, because they would be losing influence and control. But a better way to think about it is that the Eurozone contracts out (to the IMF) the tricky business of deciding whether a government’s debt is sustainable or not. That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’.

[1] Of the countries polled here, only two had more people thinking the euro had been bad rather than good for their country: Italy and Cyprus. See also Andrew Watt here.

Greece and Trust

Nick Rowe pulls me up on a point that I didn’t make in my account of what should have happened to Greece after 2010. I argued that some external body (e.g. IMF) should lend sufficient money for Greece to be able to achieve primary surplus (taxes less non-interest government spending) gradually, thereby avoiding unnecessary unemployment. Gradual adjustment is required because the improvement in competitiveness required to achieve ‘full employment’ with a primary surplus cannot happen overnight because of price rigidity.

Nick’s point is that for this to happen, the external body has to have a degree of trust in Greece: trust that it will not take the money and at some stage default on this new loan. This trust may be particularly problematic if Greece had defaulted on its original debt, which I think it should have done. This, after all, is one reason why Greece would not be able to get such finance from the markets.

This is what the IMF is for. Governments are more reluctant to upset the international community, and so defaults on IMF loans are rare. As Ken Rogoff writes: “Although some countries have gone into arrears, almost all have eventually repaid the IMF: the actual realized historical default rate is virtually nil.”

But does this help explain why other Eurozone countries keep going on about how Greece has lost their trust? I think the answer is a clear no. In fact I would go further: I think this talk of lost trust is largely spin. The issue of trust might have explained the total amount the Troika lent from 2010 to 2012. However, as I have said often, the mistake was not that the total sum lent to Greece was insufficient, but that far too much of it went to bail out Greece’s private sector creditors, and too little went to ease the transition to primary surplus. (The mistake is hardly ever acknowledged by the Troika’s supporters. Martin Sandbu discusses the - misguided - reasons for that mistake. [0])

The reason the Troika give for lack of trust is that Greece has repeatedly ‘failed to deliver’ on the various conditions that the Troika imposed in exchange for its loans. The Troika has tried to micromanage Greece to such an extent that there will always be ‘structural reforms’ that were not implemented, and it is very difficult to aggregate structural reforms. However this is exactly what the OECD tries to do in this document, and if I read Figure 1.2 (first panel) correctly, Greece has implemented more reform from 2011 to 2014 than any other country. [1] We can more easily quantify austerity, and here it is clear that Greece has implemented almost twice as much austerity as any other country. [4] The narrative about failing to deliver is just an attempt to disguise the fact that the Troika has largely run the Greek economy for the last five years and is therefore responsible for the results. [3]

You could argue with much more justification that the failure of trust has been on the Troika’s side. Greece was told that the austerity demanded of it would have just a small impact on growth and unemployment, and the Troika were completely wrong. They were then told if they only implemented all these structural reforms, things would come good, and they have not. You could reasonably say that the election of Syriza resulted from a realisation in Greece that the trust they had placed in the Troika was misguided.

Given these failures by the Troika, a reasonable response to the election of Syriza would have been to acknowledge past mistakes, and enter genuine negotiations. [2] After all, as Martin Sandbu points out in a separate piece, a pause in austerity in 2014 had allowed growth to return, and because Greece had achieved primary surplus new loans were only required to repay old loans. But it is now pretty clear that large parts of the Troika never had any real wish to reach an agreement. Over the last few months we were told (and the media dutifully repeated) that the lack of any agreement was because the ‘irresponsible adolescents’ of Syriza did not know how to negotiate and kept changing their minds. We now know that this was yet more spin to hide the truth that large parts of the Troika wanted Grexit.

The lesson of the last few months, and particularly the last few days, is not that Greece failed to gain the trust of the Troika. It is that creditors can be stupidly cruel, and when those creditors control your currency there is very little the debtor can do about it. 

 

[0] Greece was prevented from defaulting because of fears of contagion of one kind or another, which meant that Greece was taking on a burden for the sake of the rest of the Eurozone. The right response to these fears was OMT, and direct assistance to private banks, as Ashoka Mody explains clearly here. But given that this was not done, what should have then happened is that once that fear had passed, the debt should have been written off. But politicians cannot admit to what they did, so the debt that was once owed to private creditors and is now owed to the Troika remains non-negotiable.

 

[1] The Troika can also speak with forked tongues on this issue: see Mean Squared Errors here (HT MT).

[2] I am often told that the Troika had to stand firm because of a moral hazard problem: if Greek debts were written down, other countries would want the same. But the moral hazard argument has to be used proportionately. Crashing an economy to avoid others asking for debt reductions is the equivalent of the practice in 18th century England of hanging pickpockets.

[3] I am sometimes asked why I focus on the failures of the Troika rather than the mistakes of Syriza. The answer is straightforward - it is Troika policy that is the major influence on what happens in Greece. And when the Troika gives Greece’s leaders the choice between two different disasters, it seems rather strange to focus on the behaviour of Greece’s leaders.

[4] Postscript: Peter Doyle suggests that, all things considered, Greece overachieved on fiscal adjustment     

The Great Recession and the Eurozone crisis

Pandemonium erupted in Congress yesterday as senators disagreed on how to deal with the subprime problem. Borrowers are still finding it difficult to repay, despite the government buying these mortgages from the banks seven years ago and imposing strict conditions on the borrowers. Some senators favour continuing the program of compulsory community service and self-improvement lessons, but now others in the senate are openly talking about revoking the US citizenship of these borrowers.

The Great Recession and the Eurozone crisis are normally treated as different. Most accounts of the Great Recession see this as a consequence of a financial crisis caused by profligate lending by - in particular - US and UK banks. The crisis may have originated with US subprime mortgages, but few people blame the poor US citizens who took out those mortgages for causing a global financial crisis.

With the Eurozone crisis that started in 2010, most people tend to focus on the borrowers rather than the lenders. Some ill-informed accounts say it was all the result of profligate periphery governments, but most explanations are more nuanced: in Greece government profligacy for sure, but in Ireland and other countries it was more about excessive private sector borrowing encouraged by low interest rates following adoption of the Euro. Seeing things this way, it is a more complicated story, but still one that focuses on the borrowers.

However if we see the Eurozone crisis from the point of view of the lenders, then it once again becomes a pretty simple story. French, German and other banks simply lent much too much, failing to adequately assess the viability of those they were lending to. Whether the lending was eventually to finance private sector projects that would end in default (via periphery country banks), or a particular government that would end up defaulting, becomes a detail. In this sense the Eurozone crisis was just like the global financial crisis: banks lent far too much in an indiscriminate and irresponsible way.

If borrowers get into difficulty in a way that threatens the solvency of lending banks, there are at least two ways a government or monetary union can react. One is to allow the borrowers to default, and to provide financial support to the banks. Another is to buy the problematic loans from the banks (at a price that keeps the banks solvent), so that the borrowers now borrow from the government. Perhaps the government thinks it is able to make the loans viable by forcing conditions on the borrowers that were not available to the bank.

The global financial crisis was largely dealt with the first way, while at the Eurozone level that crisis was dealt with the second way. Recall that between 2010 and 2012 the Troika lent money to Greece so it could pay off its private sector creditors (including many European banks). In 2012 there was partial private sector default, again financed by loans from the Troika to the Greek government. In this way the Troika in effect bought the problematic asset (Greek government debt) from private sector creditors that included its own banks in such a way as to protect the viability of these banks. The Troika then tried to make these assets viable in various ways, including austerity. Two crises with the same cause but very different outcomes.

The Eurozone’s cover-up over Greece

Whenever I write about Greece, a large proportion of comments (maybe not a majority) could be summarised as follows: how can you side with Greece when its economy is so inefficient and its governments so inept and after everything we have done for them. I have no illusions about the inefficiencies and corruption endemic within the Greek economy. Nor do I want to become an apologist for any Greek government.

What does seem to me very misguided is the idea that European policymakers have already been generous towards Greece. The general belief is that had they not stepped in austerity in Greece would have been far worse. This seems simply wrong. If European policymakers have been generous to anyone, it is the Greek government’s original creditors, which include the banks of various European and other countries.

Suppose that Eurozone policy makers had instead stood back, and let things take their course when the markets became seriously concerned about Greece at the beginning of 2010. That would have triggered immediate default, and a request from the Greek government for IMF assistance. (In reality at the end of 2009 the Euro area authorities indicated that financial assistance from the Fund was not “appropriate or welcome”: IMF 2013 para 8) In these circumstances, given the IMF’s limited resources, there would have been a total default on all Greek government debt.

If that had happened, the IMF’s admittedly large assistance programme (initially some E30 billion, but increased by another E12 billion in later years), would have gone to cover the primary deficits incurred as Greece tried to achieve primary balance. That E42 billion is very close to the sum of actual primary deficits in Greece from 2010 (which includes the cost of recapitalising Greek banks).

What that means is that the involvement of European governments has not helped Greece at all. With only IMF support, Greece would have suffered the same degree of austerity that has actually occurred. The additional money provided by the European authorities has been used to pay off Greece’s creditors, first through delaying default in 2010 and 2011, and then by only allowing partial default in 2012. (I’m not sure the two groups see the division that way, but if some of the IMF money was intended to pay off Greece’s creditors, you have to ask why the IMF should be doing that.)

It is pretty clear why the European authorities were so generous to Greece’s creditors. They were worried about contagion. (For more on this, see Karl Whelan here.) The IMF agreed to this programme with only partial default, even though their staff were unable to vouch that the remaining Greek public debt was sustainable with high probability (IMF 2013, para 14).

The key point is that the European authorities and the IMF were wrong. Contagion happened anyway, and was only brought to an end when the ECB agreed to implement OMT (i.e. to become a sovereign lender of last resort).This was a major error by policymakers - they ‘wasted’ huge amounts of money trying to stop something that happened anyway. If Eurozone governments had needlessly spent money on that scale elsewhere, their electorates would have questioned their competence.

This has not happened, because it has been so easy to cover-up this mistake. Politicians and the media repeat endlessly that the money has gone to bail out Greece, not Greece’s creditors. If the money is not coming back, it becomes the fault of Greek governments, or the Greek people. That various Greek governments, at least until recently, agreed to participate in this deception is lamentable, although they might respond that they were given little choice in the matter. (Some of a more cynical disposition might have wondered how many of the creditors were rich Greeks.)

The deception has now developed its own momentum. What should in essence be a cooperative venture to get Greece back on its feet as soon as possible has become a confrontation saga. If the story is that all this money has gone to Greece and they still need more, harsh conditions including further austerity must be imposed to justify further 'generosity'. Among the Troika, hard liners can play to the gallery by appearing tough, perhaps believing that in the end they will be overruled by more sensible voices. The problem with this saga is similar to the problem with imposing further austerity - you harm the economy you are supposed to be helping. (Some see a more sinister explanation for what is currently going on, which is an attempt at regime change in Greece.)

That this is happening is perhaps not too surprising: politicians act like politicians often act. The really sad thing is that playing to the gallery seems to work: politicians using the nationalist card can deflect criticism that should be directed at them for their earlier mistakes. It happens all the time of course: see Putin and the Ukraine, or Scotland and the 2015 UK election. I wonder whether there will ever come a time when this cover-up strategy fails. Futile though it might be, I just ask those who might see this as an ungrateful nation always demanding more to realise they are being played.

Default panic and other tall stories

People still say to me that the UK or the US had to embark on austerity, because otherwise the markets would have taken fright at the ‘simply huge’ budget deficit. How do they know this? Because people ‘close to the market’ keep telling them so.

What can I do to show that this is wrong? The most obvious point is that interest rates on UK or US government debt have been falling since 2008, but the response I sometimes get is that rates have only stayed low because of austerity policies. So how about looking at one very short period, around the UK general election of 2010. The election itself was on 6th May, but Gordon Brown only resigned on 10th May, and the coalition agreement was published on 12th May.

Labour were proposing a more gradual reduction in the deficit than the Conservatives, but the Liberal Democrats (the eventual coalition partners) were during the election closer to Labour. So if there was any default premium implicit in yields on UK government debt, it should have fallen between 5th May and 13th May, either because Labour were defeated, or because the LibDems capitulated on the deficit. Now you may say that the markets were anticipating a Conservative victory, but even if that is true, on 5th May there was some doubt about that, which should have been reflected in the price. The coalition agreement published on 12th May clearly states a commitment to “a significantly accelerated reduction in the structural deficit”, so that doubt should have disappeared by then. If there was a default premium in rates before 6th May, it should have fallen by 13th May.

Yield on 10 year UK government debt: source Bank of England

As you can see, rates were higher on 13th May compared to 5th May. More to the point, there was no noticeable decline in rates because fiscal consolidation was going to be greater. Now of course other things may have happened over these few days to offset any default premium effect, and you can always spin stories about how markets were concerned about a coalition government so maybe the accelerated deficit reduction was not going to happen, etc. But they are stories: in terms of the data, there is no obvious effect.

The more sophisticated defence of austerity, as here from the Permanent Secretary at the UK Treasury in reviewing William Keegan’s new book, is that there exists a ‘tipping point’ somewhere: some level of the deficit at which the markets will take fright. It is then suggested, with reference to the Eurozone crisis, once you reach that point it is very hard to return, because a vicious circle sets in. Interest rates rise, making any new debt more expensive to service, which raises the deficit itself, making default even more likely. As we do not know where that tipping point is, it is best to stay well away from it by taking precautionary action before it is reached. The problem with this argument is that having your own central bank makes a key difference, not just to the chance of a funding crisis, but to its dynamics as well.

Having your own central bank does not rule out the possibility of default. As Corsetti and Dedola explain, the costs of inflation created by monetising the debt may exceed the costs of default. Markets know that, so they may still at some point begin to suspect that default could happen. It therefore follows that the markets could get it wrong: they may begin to suspect default even when there is absolutely no intention within government to let this happen.

Suppose this fate had befallen the UK or US governments in 2010. The markets suddenly panic that the government may default, even though the government has no intention of doing so. Interest rates start rising on government debt. But both governments have a Quantitative Easing programme, which is designed to keep long term interest rates low, so their central banks respond by buying more government debt. The cost of servicing government debt does not rise, because additional money is created, so there is no vicious circle. There is plenty of time for the government to take whatever action it wishes to take to reassure the markets. And unlike the model of Corsetti and Dedola, because there is a recession and a liquidity trap, the extra money created does not immediately lead to inflation. [1]

Having your own central bank, which is already undertaking Quantitative Easing, does not just make a funding crisis a lot less likely, it also crucially changes the dynamics. If a crisis occurs, the government is not trapped in a vicious circle. This in turn means that there is no obvious reason to act in a precautionary way. So why did no one make this point nearer the time? The answer of course is that they did.

[1] If you think that in these circumstances a foreign exchange crisis will get you, you need to explain why Paul Krugman’s analysis is wrong. 

Greece and educating economists

My first and most important point: pretty well every economist I have read who has expressed an opinion on the matter recognises that a deal which gives Greece at least some of what it wants is both desirable and feasible. Yes, there is some disagreement about how bad a breakdown would be for both sides, but little doubt that both sides would be better off with an agreement that significantly reduces the degree of austerity imposed on Greece. As these negotiations are essentially about economic issues and consequences, that relative unanimity is worthy of an unprecedented intervention from the US President. (Just in case you think that sounds too complacent, in the previous link Ashoka Mody does make it clear the mistakes that some individual economists and economic institutions made getting to this point.)

The second argument I wanted to make was how this example shows the importance of knowing economic history. Defaults are not day to day events, particularly if your focus is on advanced economies, so it is important to know about how these events have gone before, and in particular how debt forgiveness in the past has had positive impacts. This includes Germany’s own history. There seems to be a growing recognition that - at least in some places - economics teaching at both degree and post-graduate levels has involved too little economic history.

Some have used events like the financial crisis to call for a complete overhaul of how economics is taught. Heterodox economists want much more pluralism, and many other social scientists want economists to be much more familiar with what they know and do. I have some sympathy with both views, but - as an economist would say - only at the margin. The reason is very simple: to go even half way towards what these heterodox economists and social scientists want would involve throwing out much that is even more valuable.

That is my third point. What has it got to do with Greece? To be able to say intelligent stuff about what is going on at the moment (which you would hope an economics education would enable you to do), you need to know quite a lot of economic theory. A lot of macro of course, but quite a bit of finance, and also at least some game theory. (Although those who know their game theory should realise that at the moment the last thing on the mind of Yanis Varoufakis is being academically accurate when speaking to particular audiences!) And if you want to get into all those ‘reforms’ imposed by the Troika, you need a lot of micro.

One of the comments on an earlier post of mine said that economists should try and be less like doctors, and more like scholars. I completely disagree. For all our imperfections, economists know a lot of useful stuff. If the last six years has taught me anything, it is how wrong things can go when basic economics is ignored. Those with economic problems to solve know this most of the time (even if advice is often ignored), which is why economics is essentially a vocational subject, not a liberal arts subject.

Of course we are not as good as doctors, and make more mistakes, although sometimes we get blamed for things that probably would have happened anyway even if we had got it right. I rather liked this study entitled ‘The Superiority of Economists’. It ends as follows:

“Thus, the very real success of economists in establishing their professional dominion also inevitably throws them into the rough and tumble of democratic politics and into a hazardous intimacy with economic, political, and administrative power. It takes a lot of self-confidence to put forward decisive expert claims in that context. That confidence is perhaps the greatest achievement of the economics profession—but it is also its most vulnerable trait, its Achilles’ heel.”

When I read this, I think of Greek finance minister Yanis Varoufakis - academic economist, and former economics blogger - and hope on this occasion the confidence is retained, and that his Achilles’ heel is just a myth.

Debt restructuring: a proposed principle

With Greece under Syriza about to enter negotiations with the Troika, there has been much discussion of what might happen, and what should happen. This post is in the ‘should’ category. In the past I have argued that the Troika should welcome the opportunity to put right earlier mistakes. There should be a large amount of guilt, or at least regret, on their side. I will say why in a minute, but just to show that I’m not living in a dreamland, read this FT piece by Reza Moghadam, the former head of the European Division of the IMF.

In reality debt restructuring is a bargaining game, but I want to suggest a general principle that any agreement should hold to. That principle is that there should be no significant increase in unemployment above its natural rate (let’s call this excess unemployment) as a direct result of having to pay interest on any government debt. Unemployment above the natural rate when there is no excess core inflation is a waste of resources as well as being damaging to most of those unemployed, so any deal that creates such unemployment, or allows it to persist, should be regarded as the result of creditors acting against the social good. Indeed you could easily argue that it involves creditors acting against their own self-interest, because the more of an economy’s resources you waste, the less is available to pay its debts.

This is why the Troika should feel guilty, because by not allowing Greece to default on all its debt back in 2010 it helped create a situation where over half young people in Greece are unemployed. Some excess unemployment was inevitable in Greece after 2010 because the country had become very uncompetitive, and the impact of this on demand had been offset by large primary budget deficits. (This problem was made worse by pre-recession cost-cutting in Germany.) However, as I have argued in the past in the context of Latvia, the efficient way to restore competitiveness is to have small but persistent excess unemployment: a ‘short sharp shock’ is much more costly. The Troika imposed much too much austerity on Greece in a futile effort to avoid full and early default.

The process transferred the ownership of the remaining Greek government debt from the private sector to the public sector - other Eurozone governments and the IMF. The transfer to other European governments was wrong in two respects. First, it was another example of governments bailing out their own banks and other financial institutions with no costs to those institutions. Second, it made any subsequent restructuring of Greek debt much more difficult politically. If there had been full and immediate default there would have still been need for additional lending to Greece to give them time to adjust their public finances and avoid a large increase in unemployment, but that is what the IMF is for. If the Troika had not been involved, the IMF may well have gone for early and complete default.

So much for the past and guilt. What about what should happen now. The priority is for Greece to reduce unemployment as quickly as possible. That would be consistent with my principle, and so should be a priority for both sides. It could be achieved, for example, by suspending all interest payments on all Greek debt immediately, with those payments resuming on any debt not written off once excess unemployment had been eliminated. Paul Krugman shows what a positive effect no longer having to run a primary surplus to pay interest could have on the Greek economy. (As Paul Krugman observes in a separate post, and OECD data confirm, the competitive position of Greece is now back to the level it was when the Euro was created.)

What about all the ‘structural reform’ that the Troika has imposed. The new Greek government is likely to introduce plenty of structural reform of its own, so encouragement from outside is hardly necessary. If it is not the structural reform that the Troika prefers, then I’m afraid that is the price you pay for having a democratic Europe. We know that some within the Eurozone bureaucracy have little respect for national sovereignty, and it is time these people were put in their place.  

What about the backlash from voters in Northern Europe? I find arguments that say this should be (we are talking about what should happen here) a barrier to debt restructuring hard to take seriously. Northern Europe’s politicians foolishly socialised the Greek debt held by their own country’s financial institutions. To say Greece has to pay the price of this mistake seems perverse. What about other periphery countries wanting to revise the terms they were required to accept for Troika help? Well maybe they are right to do so. And finally what about the argument that this would ‘frighten the markets’ (always a good tell by the side that uses it that their argument is weak)? The markets will be unsettled far more if negotiations break down because creditors refuse to give enough.

Germany is now the third most popular country of origin for pageviews of my blog, which is something I’m very happy about. I’m sure at least some of those readers will be worrying that any renegotiation violates ‘the law’, or at least contracts that have been previously agreed. I have very little sympathy with that argument. The British government was also protecting the rule of law when it provided armed guards to ensure that shipments of grain left Ireland during the famine of the 1840s.

Even if you do not accept my argument about the role that creditors played in inflicting great harm on the Greek economy and people in the past, these creditors have a clear choice for the future. Current levels of unemployment in Greece represent a criminal waste of resources and source of unhappiness, and it should be brought to an end as soon as possible. Creditors can make this happen with a small economic cost to themselves by at least suspending all interest payments until the Greek economy has recovered. It is a cost that creditors are almost certainly going to have to pay at some point anyway. As Martin Wolf says in an excellent column, “What cannot be paid will not be paid.” It would be much better for the Greek people and Europe as a whole for the Troika to admit this now rather than later.    

Let us hope for a Syriza victory

If you think this sentiment is dangerous, because you have read that if this left wing party formed a government after the forthcoming Greek elections the Eurozone would be plunged into crisis, I suspect you should reconsider where you get your information from.[1] Here is why.

Syriza wants to reduce the burden of Greek government debt by various means, which would clearly benefit Greece and mean losses for its creditors. Its bargaining position is strong because the government is running a primary surplus. This means that if all debt was written off and the Greek government was unable to borrowing anything more, it would be immediately better off because taxes exceed government spending. In contrast the creditors’ position in such a situation is normally very weak, which is why some kind of deal is usually done to reduce the debt burden. Creditors take a hit, but not as bad a hit as they would if all debt was written off.

It might appear as if the creditors have an extra card in this particular case - they can throw Greece out of the Eurozone. Be absolutely clear, that is a threat being made by the creditors. Greece under Syriza has no intention of leaving the Euro, even if they defaulted on all their debt, so they would have to be forced out. I have never seen it set out clearly how the rest of the Eurozone would force Greece to leave without compromising the independence of the ECB, but let’s assume that they have the power to do so. Would the Eurozone ever carry out this threat?

Expelling Greece from the Eurozone because they wanted to renegotiate their debts would be an incredibly stupid thing to do. For a start, the creditors would lose everything, because obviously Greece would go for complete default in those circumstances. In addition, individuals and markets would immediately worry that the same fate might befall other periphery countries. (The story that Dani Rodrik tells is all too plausible.) What would be the gain?

The standard answer is that by exercising this threat you prevent other periphery countries trying to follow Greece’s example. Moral hazard - the sins that have been committed in your name! In reality the interest rate on part of Greek debt has already been reduced in earlier negotiations (see also Andrew Watt here). There is nothing compelling the core countries to treat each periphery country equally - as Ireland has found out to its cost. Peter Spiegel puts it clearly in the FT:

“How radical is Mr Tsipras’ idea of a Paris Club-style debt restructuring? So radical that, according to three officials involved in the discussions, eurozone officials actively considered such a plan in late 2012. The French-led initiative would have led to Greece’s debt obligations being cut in tranches — much the same way bailout aid is granted — after meeting a series of economic reform commitments.”

So even if some in Germany were stupid and cruel enough to suggest throwing Greece out, it seems inconceivable that the rest of the Eurozone (or the IMF) would allow it. In reality reducing the debt burden in Greece (and probably elsewhere [2]) would do the Eurozone a lot of collective good. Greece would be able to relax the crippling austerity that has had disastrous economic and social consequences. The core countries and the IMF could at least partially undo the mistakes they made from 2010 to 2012 in first delaying default, and then failing to impose a complete default, mistakes IMF staff [4] at least now recognise. German taxpayers might be encouraged to understand that the problem since 2010 has not been Greek intransigence but the actions of their own governments in trying to protect their own banks and in dispensing unrealistic degrees of austerity. Philippe Legrain argues the case in detail here. As Thomas Piketty succinctly puts it, Syriza “want to build a democratic Europe, which is what we all need”.  

Following a post like this I invariably get comments that tell me about all the terrible things that still go on in Greece. I want to make two final points here. First, if things have not changed following years of acute austerity in Greece, might this mean that we need something else besides more acute austerity? Might it mean we need a move away from the traditional governing elites? [3] Second, a widely recognised measure of fiscal stance is the underlying (cyclically corrected) primary balance (the deficit less debt interest). Here is the OECD’s latest estimate for 2014. Do not complain that Greece is backsliding on austerity! And before you tell me that the law must be followed, read a post I am proud I wrote.

Underlying government primary balances 2014, OECD estimates

[1] The preliminary decision of the ECJ today might have been much more dangerous. For an excellent discussion prior to the judgement see Ashoka Mody.

[2] Barry Eichengreen and Ugo Panizza doubt whether the primary surpluses that some countries would need to run without more debt relief are politically feasible. I’m a little more optimistic, but that is different from saying that some debt renegotiation would not be beneficial in the longer term.

[3] There would be the added bonus of seeing a well known economic blogger become a politician!

[4] My initial version just said IMF, but as Peter Doyle reminds me, this staff critique was not endorsed by IMF management.