Is Merkel Putting Her Money Where Her Mouth is?

I just gave an interview about the Greek debt situation to Swiss Radio. No idea when they will broadcast it, but one of the things I suggested is that, if Mrs Merkel (and Mr Sarkozy, et al) really think that Greek debt is suffering from a "speculative attack", they should use their own money to buy Greek bonds. This would serve as a public vote of confidence, and she should make money hand-over-fist if her reasoning is right. Greece's 2040 bond is still trading at only 77 cents on the dollar in Berlin, Frankfurt, Munich, Stuttgart. If one really believes that the decline from 100 in mid-2007 is simply "speculation", then a buy-and-hold investor should salivate at the 6.3% return promised. If Merkel and friends are right, that'll be risk-free, if you hold the bond till 2040. On top, you get the upside of the bond rising back to where it should be (if you believe it is worth more than 77) sometime before 2040. Why do I like this impractical idea? First, it shows that Greek's travails have nothing to do with speculation. Problems with incentives in financial markets are plentiful, but this particular episode has nothing to do with a bear attack. Second, once Mrs Merkel and friends own tons of Greek debt, they cannot possibly use taxpayer funds for a bailout...

Greece and 1+1 of debt dynamics

When is Greece going to go bust? It may sound a little harsh, but without help from the outside, I see very little hope for the indebted Euro member by the Aegan to avoid such an outcome. As we teach our students in the ITFD class on financial crises, one of the easiest ways to think about debt sustainability is to ask – what would it take to stabilize the debt/GDP ratio? If you start with debt of value x relative to GDP, then debt tomorrow will grow by the interest you pay. If there is growth, more debt in nominal terms can be supported more easily, and if you generate a surplus and repay some debt, it’s all honkey-dory. Pick a growth rate you believe is plausible, and an interest rate at which the government can borrow. The number you get is what the primary surplus should be to stabilize the debt/GDP ratio. Primary surplus doesn’t mean a fiscal surplus – it just means that your revenue is greater than your expenditure excluding debt servicing costs. If you play with the basic numbers a bit, you get something like this for the case of Greece.

Here, g is the growth rate, and i is the interest rate. If growth from now on is 2%, and the Greek government can borrow at 3%, then the government only needs a primary surplus of 1.1%. This is not too hard to achieve. If, on the other hand, interest rates go to 9%, then you need a surplus of 7.8% p.a. If growth dwindles, it gets ever harder to stabilize debt/GDP ratios. At 0% growth and 9%, we are talking 10.2% of a primary surplus. So just how bad is the situation in Greece? Needless to say, the government is currently not running a primary surplus – it’s in deficit, to the tune of 7.7% (thanks to DB Research for the figure). In the table, I have highlighted in bold the combination of figures that I think are plausible in the intermediate future. I am being optimistic here – even 0% growth is a good outcome given how uncompetitive the county is, and how bad the drag from fiscal consolidation will be. We are talking here of a swing of around 15% of GDP.

Overall, I fear this is a no-hoper unless the EU rides to the rescue on a white stallion. Fiscal consolidation on the scale required of Greece is beyond even the most cohesive states. I cannot think of countries other than after a major war producing such a shift in their public finances. Germanyin the early 1930s under Brüning tried to engineer a swing in the public accounts that was of a similar magnitude (it reduced nominal spending by about 1/3 from 1928-32). The budget cuts were so severe that Brüning became known as the ‘Hunger Chancellor’. Many believe that the program of fiscal consolidation enacted by his government undid the Weimar Republic.

Let’s get back to the little table. I think that a range of 5-9% for the interest rate is pretty optimistic, too – as creditors start to worry that Greece may not repay, they will demand ever higher interest rates. This creates a self-fulfilling dynamic, of the type that some politicians have branded “speculative attack”. It is, of course, nothing of the sort – nobody is manipulating markets here, rising interest rates just mean that, as a borrower looks ever worse, creditors are not keen to refinance them. Kehoe and Cole have a very nice paper, inspired by the Mexican crisis, on self-fulfilling sovereign debt crises, and Wei Xiong of Princeton has some new work on rollover risk (as applied to private firms).

So what should be done? Many equate default with a cataclysmic meltdown. This is not entirely without reason. As Rogoff, Reinhart, and Sevastano show in their paper on serial defaults, these can seriously damage your “fiscal health” – the state institutions you need to build a modern tax state. On the other hand, there is pretty convincing literature arguing that, since governments rarely sell contingent debt, defaults are a way to achieve market completeness. Investors de facto anticipate that things can go wrong, and the higher interest they receive beforehand compensates them for the risk. Defaults are when countries collect on the ‘insurance’ they bought before. Theories in the ‘excusable default’ vein (Grossman-Van Huyck, say) require that defaults happen in verifiably bad states of the world, and are driven by exogenous events. Half of that at least applies to Greece – things really are bad. One can argue if accounting fraud and an unwillingness to create a functioning tax bureaucracy qualify as exogenous. Be that as it may, it remains unclear why the burden of adjustment should exclusively fall on the Greek taxpayers, instead of bond holders.