http://economix.blogs.nytimes.com/2010/05/06/its-not-about-greece-anymore
May 6, 2010, 6:11 am
It’s Not About Greece Anymore
By PETER BOONE AND SIMON JOHNSON
Louisa Gouliamaki/Agence France-Presse — Getty Images Protesters
at the Acropolis in Athens waved flags and hung banners in front
of the Parthenon.
Peter Boone is chairman of the charity Effective Intervention and
a research associate at the Center for Economic Performance at the
London School of Economics. He is also a principal in Salute
Capital Management Ltd. Simon Johnson, the former chief economist
at the International Monetary Fund, is the co-author of “13 Bankers.”
The Greek “rescue” package announced last weekend is dramatic,
unprecedented and far from enough to stabilize the euro zone.
The Greek government and the European Union leadership, prodded by
the International Monetary Fund, are finally becoming realistic
about the dire economic situation in Greece. They have abandoned
previous rounds of optimistic forecasts and have now admitted to a
profoundly worse situation. This new program calls for “fiscal
adjustments” — cuts to the fiscal deficit, mostly through spending
cuts — totaling 11 percent of gross domestic product in 2010, 4.3
percent in 2011, and 2 percent in 2012 and 2013. The total
debt-to-G.D.P. ratio peaks at 149 percent in 2012-13 before
starting a gentle glide path back down to sanity.
This new program is honest enough to show why it is unlikely to
succeed.
Daniel Gros, an eminent economist on euro zone issues who is based
in Brussels, has argued that for each 1 percent of G.D.P. decline
in Greek government spending, total demand in the country falls by
2.5 percent of G.D.P. If the government reduces spending by 15
percent of G.D.P. — the initial shock to demand could be well over
30 percent of G.D.P.
Obviously this simple rule does not work with such large numbers,
but it illustrates that Greece is likely to experience a very
sharp recession — and there is substantial uncertainty around how
bad the economy will get. The program announced last weekend
assumes the Greek G.D.P. falls by 4 percent this year, then by
another 2.6 percent in 2011, before recovering to positive growth
in 2012 and beyond.
Such figures seem extremely optimistic, particularly in the face
of the civil unrest now sweeping Greece and the deep hostility
expressed toward the country in some northern European policy circles.
The pattern of growth is critical because, under this program,
Greece needs to grow out of its debt problem soon. Greece’s
debt-to-G.D.P. ratio will be a debilitating 145 percent at the end
of 2011.
Now consider putting more realistic growth figures into the I.M.F.
forecast for Greece’s economy — e.g., with G.D.P. declining 12
percent in 2011, then the debt-to-G.D.P. ratio may reach 155
percent. At these levels, with a 5 percent real interest rate and
no growth, the country needs a primary surplus at 8 percent of
G.D.P. to keep the debt-to-G.D.P. ratio stable. It will be
nowhere near that level. The I.M.F. program has Greece running a
primary budget deficit of around 1 percent of G.D.P. in that year,
and that assumes a path for Greek growth that can be regarded only
as an “upside scenario.”
The politics of these implied budget surpluses remains brutal.
Since most Greek debt is held abroad, roughly 80 percent of the
budget savings the Greek government makes go straight to Germans,
the French and other foreign debt holders (mostly banks). If
growth turns out poorly, will the Greeks be prepared for
ever-tougher austerity to pay the Germans? Even if everything goes
well, Greek citizens seem unlikely to welcome this version of
their “new normal.”
Last week the European leadership panicked — very late in the day
— when it realized that the euro zone itself was at risk of a
meltdown. If the euro zone proves unwilling to protect a member
like Greece from default, then bond investors will run from
Portugal and Spain also — if you doubt this, study carefully the
interlocking debt picture published recently in The New York
Times. Higher yields on government debt would have caused
concerns about potential bank runs in these nations, and then
spread to more nations in Europe.
When there is such a “run,” it is not clear where it stops. In
the hazy distance, Belgium, France, Austria and many others were
potentially at risk. Even the Germans cannot afford to bail out
those nations.
Slapped in the face by this ugly scenario, the Europeans decided
to throw everything they and the I.M.F. had at bailing out Greece.
The program as announced has only a small chance of preventing
eventual Greek bankruptcy, but it may still slow or avert a
dangerous spiral downward — and enormous collateral damage — in
the rest of Europe.
The I.M.F. floated in some fashion an alternative scenario with a
debt restructuring, but this was rejected by both the European
Union and the Greek authorities. This is not a surprise; leading
European policy makers are completely unprepared for broader
problems that would follow a Greek “restructuring,” because
markets would immediately mark down the debt (i.e., increase the
yields) for Portugal, Spain, Ireland and even Italy.
The fear and panic in the face of this would be unparalleled in
modern times: When the Greeks pay only 50 percent on the face
value of their debt, what should investors expect from the
Portuguese and Spanish? It all becomes arbitrary, including which
countries are dragged down.
Someone has to decide who should be defended and at what cost, and
the European structures are completely unsuited to this kind of
tough decision-making under pressure.
In the extreme downside scenario, Germany is the only obvious safe
haven within the euro zone, so its government bond yields would
collapse while other governments face sharply rising yields. The
euro zone would likely not hold together.
There is still a narrow escape path, without immediate debt
default and the chaos that that would produce:
1. Talk down the euro — moving toward parity with the American
dollar would help lift growth across the euro zone.
2. As the euro falls, bond yields will rise on the euro zone
periphery. This will create episodes of panic. Enough short-term
financing must be in place to support the rollover of government debt.
3. Once the euro has fallen a great deal, announce the
European Central Bank will support the euro at those levels (i.e.,
prevent appreciation, with G-20 tacit agreement), and also support
the peripheral euro zone nations viewed as solvent by buying their
bonds whenever markets are chaotic.
4. At that stage, but not before, the euro zone leadership
needs to push weaker governments to restructure. That will include
Greece and perhaps also Portugal. Hopefully, in this scenario
Spain can muddle through.
5. European banks should be recapitalized as necessary and
have most of their management replaced. This is a massive failure
of euro groupthink — including most notably at the political level
— but there is no question that bank executives have not behaved
responsibly in a long while and should be replaced en masse.
To the extent possible, some of the ensuing losses should be
shared with bank creditors. But be careful what you wish for. The
bankers are powerful for a reason; they have built vital yet
fragile structures at the heart of our economies. Dismantle with care.
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