Daniel Gros: Greece’s Soft Budgets in Hard Times

BRUSSELS – The first de facto default of a country classified as “developed” has now taken place, with private international creditors “voluntarily” accepting a “haircut” of more than 50% on their claims on the Greek government. As a result, Greece now owes very little to private foreign creditors.

Greece also agreed to even more stringent budget targets and, in return, received financial support of more than €100 billion ($134 billion). The purpose of the entire package is to avoid a full-scale default and allow the country to complete its financial adjustments without overly unsettling financial markets. But this approach (a haircut on private-sector debt plus fiscal adjustment) is unlikely to work on its own.

The real problem in Greece is no longer the fiscal deficit, but a combination of deposit flight and continuing excessive consumption in the private sector, which for more than a decade now has been accustomed to spending much more than it earns. This over-consumption had been financed (at least until now) by the government, and, as a consequence, most of the foreign debt comprised public-sector liabilities. The official line is that Greek over-consumption will cease once the government reins in expenditure and increases taxes.

But this might not turn out to be the case. The Greek population has become accustomed to consuming above its means; and it can continue to do so because it effectively faces what the Hungarian economist János Kornai, analyzing the failings of socialism, called “a soft budget constraint.” When Greek households have to pay higher taxes, they can simply withdraw the funds from their savings accounts and continue spending much as before. That is why, despite the strong fiscal adjustment, Greece’s current-account deficit remains close to 10% of GDP.

Moreover, depositors have increasingly withdrawn their funds from Greek banks and transferred the money abroad. Estimates vary, but the best guess seems to be €50 billion, which is equivalent to a whopping 25% of GDP.

This cannot go on. Greece cannot regain access to financial markets until the current-account deficit is eliminated and deposit flight stops.

Unfortunately, the opportunity cost of keeping a bank deposit in Greece is rather low. Greek banks currently pay their depositors only about 2.8% interest. While this is better than zero at a German bank, the difference is too small to make a difference, given the real danger that Greece might have to leave the eurozone, which would render local deposits worthless. 

So interest rates must thus be substantially increased to induce Greek savers to keep their deposits and thus stop the hemorrhage from the Greek banking system. At the same time, the cost of financing excessive expenditure must also be increased; otherwise, the current-account deficit will persist.

The cost of credit for the Greek private sector remains surprisingly low for an economy that has been totally cut off from foreign capital markets, and whose government cannot obtain private funds under any terms. The average cost of new loans to Greek enterprises and households is still only 6-7%. This might appear substantial, but it is only a few percentage points higher than in Germany.

This must change. Estonia, which had an even larger current-account deficit before the crisis, provides an interesting counterexample. There, borrowing costs for new loans shot higher than 40% when the financial crisis erupted. This led to a very sharp adjustment in domestic consumption. But this brutal adjustment quickly turned the current-account balance into a surplus, and the country’s creditworthiness was never questioned.

But why are interest rates in Greece still so low? The answer is simple: Greek banks still have access to financing from the European Central Bank at very low rates (1-3%). As long as this flow of cheap money continues, so will capital flight; no adjustment in consumption will take place so long as the country faces only a very soft budget constraint.

This is also the reason why the existing adjustment program would not be sufficient even if the Greek government were to implement everything as planned. If nothing is done to stop the capital flight and reduce private domestic expenditure, the Greek banking system will become ever more dependent on “monetary” financing. But the ECB has already provided about €120 billion (60% of Greek GDP) to Greece’s banks, and cannot tolerate any further increase in its exposure to a country that has just defaulted.

Massive increases in domestic interest rates might still be sufficient to induce savers to keep their deposits at home. If this is not done quickly, deposit flight is likely to escalate, and the government will in the end have to impose a freeze on deposits or capital controls. But any move of this kind would lead to a breakdown of the Greek banking system and, potentially, to massive contagion affecting Portugal, Spain, and Italy.

If Europe’s policymakers do not recognize that deposit flight and continuing excessive private expenditure constitute the real danger to the adjustment program in Greece, they might soon have to deal with another crisis – hard to imagine today – of even bigger proportions.

Daniel Gros is Director of the Center for European Policy Studies.

Daniel Gros: Austerity under Attack

BRUSSELS – Europe seems to be obsessed with austerity. Country after country is being forced by either the financial markets or the European Union to start cutting its public-sector deficit. And, as if this were not enough, 25 of the 27 EU member states have just agreed on a new treaty (called a “fiscal compact”) that would oblige them never to have a cyclically adjusted budget deficit of more than 0.5% of GDP. (For comparison, the United States’ budget deficit in 2011 was close to 8% of GDP).

But, as the European economy risks falling into recession, many observers are asking whether “austerity” could be self-defeating. Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?

This is highly unlikely, given the way our economies work. Moreover, if it were true, it would follow that tax cuts would reduce budget deficits, because faster economic growth would generate higher revenues, even at lower tax rates. This proposition has been tested several times in the US, where tax cuts were invariably followed by higher deficits.

In Europe, the concern today is instead with the debt/GDP ratio. The worry here is that the GDP drop resulting from “austerity” might be so large that the debt ratio increases. This matters, because investors often use the debt ratio as an indicator of financial sustainability. Thus, a lower deficit might actually heighten tensions in financial markets.

However, a lower deficit must lead over time to a lower debt ratio, even if this ratio worsens in the short run. After all, most models used to assess the economic impact of fiscal policy imply that a cut in expenditure, for example, lowers demand in the short run, but that the economy recovers after a while to its previous level. So, in the long run, fiscal policy has no lasting impact (or only a very small one) on output. This implies that whatever short-run negative impact lower demand may have on the debt ratio should be offset later (in the medium to long run) by the rebound in demand that brings the economy back to its previous output level.

Moreover, even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.

Notice that this conclusion was reached without any recourse to what Paul Krugman and others have derided as the “confidence fairy.” In the US, it might indeed be unreasonable to expect that a lower deficit translates into a lower risk premium – for the simple reason that the US government pays already ultra-low interest rates.

But, even without any confidence effects, the bipartisan Congressional Budget Office has concluded that, while cutting the US deficit does lower demand, it still leads reliably to a lower debt ratio. This should be all the more true for eurozone countries, like Italy or Spain, that are now paying risk premia in excess of 3-4%. For these countries, the confidence fairy has become a monster.

The decisive question then becomes: What matters more, the impact of deficit cutting on the debt/GDP ratio in the short run or in the long run?

Prospective buyers of Italian ten-year bonds should look at the longer-term impact of deficit cutting on the debt level, which is pretty certain to be positive. Of course, some market participants might not be rational, demanding a higher risk premium following a short-term deterioration of the debt ratio. But those concentrating on the short term risk losing money, because the risk premium will eventually decline when the debt ratio turns around.

Abandoning austerity out of fear that financial markets might be short-sighted would only postpone the day of reckoning, because debt ratios would increase in the long run. Moreover, it is highly unlikely that Italy, for example, would pay a lower risk premium if it ran larger deficits.

It would be dangerous for the eurozone’s highly indebted countries to abandon austerity now. Any country that enters a period of heightened risk aversion with a large debt overhang faces only bad choices. Implementing credible austerity plans constitutes the lesser evil, even if this aggravates the cyclical downturn in the short run.

Daniel Gros is Director of the Center for European Policy Studies.

Daniel Gros:The Decline and Fall of the Euro?

BRUSSELS – Great empires rarely succumb to outside attacks. But they often crumble under the weight of internal dissent. This vulnerability seems to apply to the eurozone as well.

Key macroeconomic indicators do not suggest any problem for the eurozone as a whole. On the contrary, it has a balanced current account, which means that it has enough resources to solve its own public-finance problems. In this respect, the eurozone compares favorably with other large currency areas, such as the United States or, closer to home, the United Kingdom, which run external deficits and thus depend on continuing inflows of capital. 

In terms of fiscal policy, too, the eurozone average is comparatively strong. It has a much lower fiscal deficit than the US (4% of GDP for the eurozone, compared to almost 10% for the US).
Debasement of the currency is another sign of weakness that often precedes decline and breakup. But, again, this is not the case for the eurozone, where the inflation rate remains low – and below that of the US and the UK. Moreover, there is no significant danger of an increase, as wage demands remain depressed and the European Central Bank will face little pressure to finance deficits, which are low and projected to disappear over the next few years.

Refinancing government debt is not inflationary, as it creates no new purchasing power. The ECB is merely a “central counterparty” between risk-averse German savers and the Italian government.

Much has been written about Europe’s sluggish growth, but the record is actually not so bad. Over the last decade, per capita growth in the US and the eurozone has been almost exactly the same.

Given this relative strength in the eurozone’s fundamentals, it is far too early to write off the euro. But the crisis has been going from bad to worse, as Europe’s policymakers seem boundlessly capable of making a mess out of the situation.

The problem is the internal distribution of savings and financial investments: although the eurozone has enough savings to finance all of the deficits, some countries struggle, because savings no longer flow across borders. There is an excess of savings north of the Alps, but northern European savers do not want to finance southern countries like Italy, Spain, and Greece.

That is why the risk premia on Italian and other southern European debt remain at 450-500 basis points, and why, at the same time, the German government can issue short-term securities at essentially zero rates. The reluctance of Northern European savers to invest in the euro periphery is the root of the problem.

So, how will northern Europe’s “investors’ strike” end?

The German position seems to be that financial markets will finance Italy at acceptable rates if and when its policies are credible. If Italy’s borrowing costs remain stubbornly high, the only solution is to try harder.

The Italian position could be characterized as follows: “We are trying as hard as humanly possible to eliminate our deficit, but we have a debt-rollover problem.”

The German government could, of course, take care of the problem if it were willing to guarantee all Italian, Spanish, and other debt. But it is understandably reluctant to take such an enormous risk – even though it is, of course, taking a big risk by not guaranteeing southern European governments’ debt.

The ECB could solve the problem by acting as buyer of last resort for all of the debt shunned by financial markets. But it, too, is understandably reluctant to assume the risk – and it is this standoff that has unnerved markets and endangered the euro’s viability.

Managing a debt overhang has always been one of the toughest challenges for policymakers. In antiquity, the conflicts between creditors and debtors often turned violent, as the alternative to debt relief was slavery. In today’s Europe, the conflict between creditors and debtors takes a more civilized form, seen only in European Council resolutions and internal ECB discussions.But it remains an unresolved conflict. If the euro fails as a result, it will not be because no solution was possible, but because policymakers would not do what was necessary.

The euro’s long-run survival requires the correct mix of adjustment by debtors, debt forgiveness where this is not enough, and bridge financing to convince nervous financial markets that the debtors will have the time needed for adjustment to work. The resources are there. Europe needs the political will to mobilize them.

Daniel Gros is Director of the Center for European Policy Studies.