Beware of Greeks bearing gilts.

With the recent Greek referendum on the bailout package yielding a pretty resounding “no” to further austerity, the Greek-Eurozone crisis is set to move into a new and unprecedented phase. No solution seems in sight to this seemingly intractable and persistent tragedy. The ways forward are all fairly unappetizing to at least one large group of voters. One approach involves some sort of continued and largely European financial support for Greece. Such a solution would represent a considerable climb-down for many European governments, who would likely suffer potentially severe domestic political costs that have just been increased by the Greek government’s negotiating tactics. The other main option is for Greece to effectively declare bankruptcy and, most likely, leave the Eurozone. While it is certainly easier and safer to just sit back and watch how it unfolds rather than try to prescribe or predict a solution to this mess, I am going to instead sketch out what I think could be the outline of a way forward.

There are a few basic elements of the crisis that underpin my analysis. First, the ultimate cause of the debacle is excessive lending, primarily to the Greek government by the European financial sector. The origins of this excess are multiple, but the essence is that entering the Eurozone allowed Greece to borrow at dramatically lower interest rates (falling from well over 10 percent in the pre-Euro period to under 3 percent post-Euro and pre-crisis); not surprisingly they began borrowing a lot more. Simultaneously Euro-enthusiasm – not to mention the endless search for even a few extra basis points of yield – clouded the judgement of lender’s regarding Greece’s capacity to carry debt. Mixed in there, undoubtedly, has been the international financial system’s chronic inability to deal intelligently and credibly with sovereign bankruptcy (the inability of a government to repay its debts) and the concomitant reliance on bailing out the banks by replacing them with financing from official bilateral (in this case read other European countries) or multilateral (the IMF) sources. So ultimately the banks ought to be bearing much of the cost of the crisis, since they did not do the due diligence required to ensure the safekeeping of their depositor’s savings. They have been bailed out, however, as the political economy of crisis induces governments, with frightening regularity, to bail out the financial sector for fear of a wider collapse in the economy, and even greater fear of a widespread collapse in their votes from citizens suddenly dispossessed of their savings. Any solution to this crisis must address this fundamental failure of domestic politics and the international financial system.

Second, the Greeks themselves certainly bear a significant amount of the blame for this mess. Many of their fellow Europeans would put a lot of emphasis on the fact that Greek voters elected in serial fashion governments that were, at best, fairly imprecise on matters of financial reporting and management. The apparent cooking of the government’s books went some way in misleading lenders. And, while understandable, there seemed to be little appetite on the part of Greek voters to question in any serious manner why many of their social services were provided at levels beyond their EU counterparts, but without an equivalent tax effort. This collective Panglossian indulgence facilitated a social pyramid scheme that now seems to have reached its painful but inevitable end. Consequently it is not unreasonable to place a significant component of the blame for the crisis on the Greeks themselves, a perspective being taken in many of the coffee shops and governments of most other European countries, and particularly or most significantly in Germany.

The third element, however, is that Greeks have already shouldered an enormous burden of adjustment through the course of successive bailout packages. The extent of the fiscal shock has been almost unprecedented. Two points are worth noting. First, we are well beyond the point where further austerity can improve the creditworthiness of Greece, since the numerator of the debt-to-GDP ratio is falling more slowly than the denominator. The simple fact, as the IMF itself has recognized, is that Greece is effectively insolvent and there needs to be debt relief. We have already seen this stage play, part farce and part tragedy, through successive rounds of developing country debt restructuring and debt relief. The lessons from these earlier episodes seemed clear enough: debt must be reduced to create incentives and free up resources for new investment and growth, and to hopefully ease hardships for the poorest. While Greece’s rich-country status and EU membership has obscured this lesson, it nonetheless is equally relevant here, just as the basic principle of debt write-downs is widely accepted in bankruptcy law for the private sector within a national jurisdiction. And just as is the case in corporate bankruptcy, the process of debt relief must also be accompanied by often painful adjustment (traditionally formalized in IMF “conditionality”) as well as losses for investors (the proverbial “haircut”).

The irreconcilable element of this puzzle is that many Europeans do not want to let Greece of the hook partly because of their culpability in the whole affair, but also for fear of setting precedents that induce irresponsible behavior by other member states in the future. Not accepting a debt write down, or at least a meaningful easing of the debt burden for the foreseeable future, however, is a recipe for more needless economic pain. The current impasse has already contributed to a damaging liquidity crisis that only threatens to get worse. Wishing to punish the Greek population, while understandable at an emotional level, has nothing to do with economic efficiency. Greece has already endured a 25 percent decline in economic activity; how much more suffering is necessary?

Economics suggests that debt relief is indeed necessary. The Europeans should offer it with grace, since the alternative is to accept it anyway along with a healthy dose of justifiable Greek anger and serious concerns about the viability of the European project. Their more serious concern is the implications for the future. We have to accept that failure in the financial system has occurred, but just because the Greek (or Trojan?) horse may have bolted from the Eurobarn doesn’t mean we can’t or shouldn’t try and shut the door on future crises, the only sensible policy when there are other horses inside. The following sketch is a suggestion of the broad elements of how to achieve such closure.

First, the Europeans should look for better tools to impose strict limits on debt sustainability measures for member states. Such limits are already part of the Fiscal Compact (known more formally as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union), which replaced the earlier Stability and Growth Pact. The compact is enforced through fines on governments for exceeding prescribed limits on debts and deficits. The Stability and Growth Pact, however, failed miserably, in large part because of breaches in it by the French and German governments, and because it is not very sensible to ask near-bankrupt countries in crisis to pay fines. The enforcement mechanism needs to be reinforced by placing greater onus on the private financial system and financial regulators. Banks collectively should not be allowed to hold a European country’s debt beyond a predetermined limit of that country’s carrying capacity. In addition, the total exposure of these institutions to government debts should be strictly monitored and limited to protect their depositors. Since private lenders will undoubtedly find loopholes around this limit, debt holdings consistent with the rules would need to be registered with financial supervisors and cross-referenced with the borrowing reports of the governments themselves. These registered debts would then be covered by a preferably explicit insurance scheme in case of a default. There will be complaints that such a system will induce moral hazard by backstopping the lending decisions of the financial market, but the sad fact is that this moral hazard already exists due to the presence of de facto implicit insurance that is well-recognized by borrowers and lenders. If insurance is to be provided, it is better to do so transparently, within a rules-bound system, and with the possibility of charging premiums in some form. Other lenders, those not taking private deposits, could take the risk of lending above the limit, but they would also bear the consequences. While these limits would have to have some technical complexity to deal with changes in debt maturity (which would threaten the seniority of previously issued legitimate debt of longer maturity), the principles of such rules are pretty straightforward. Europe’s financial regulators need to be given the responsibility of formulating and enforcing these rules, hopefully insulating the process from political interference.

The second element of the program would have to make debt flows much more transparent. The pre-crisis misinformation about the Greek government’s financial situation needs to be avoided in order to enforce such regulations. Common standards and a European statistical framework needs to support these regulations (just as they are needed for the current rules to be enforced with any hope of success) and the numbers need to be made completely public in a transparent and timely fashion.

With a credible framework to minimize and hopefully avoid future problems of misbehavior on the part of governments, and more importantly on the part of financial institutions, the Europeans can perhaps take the politically difficult but economically necessary step of providing or promising some form of debt relief for the Greeks. The relief can be contingent on future economic performance, with some allowance for improved economic circumstances leading to additional (but necessarily modest) repayments (a little bit of ambiguity on the details might go a long way in allowing both sides to claim some sort of victory). Greece still needs to undergo adjustment, but these conditions need to focus mostly on longer term productivity and public finance reform, less on the short-term austerity that Greece has already endured. Hopefully this option can be adopted and facilitate Greece’s continuation in the Euro, but dealing with the failures of the financial system is equally relevant under Grexit.

Many economists have long observed that solving this crisis means walking a fine line between having just the right amount of adjustment that is enough to credibly lead to a stable medium and long term debt outlook, but not so much that it induces further recession. Walking this tightrope was never going to be easy and the Greek crisis illustrates just how tough it is. After tough negotiations and political grandstanding the two sides have painted themselves into seemingly incompatible corners defined by political absolutes. The only apparent solution is to provide relief for the short-term pain being suffered collectively by the Greek population, while assuaging the legitimate concerns about the future that are held by many of their European partners. Europe has a unique opportunity to take some positive steps towards dealing with the problem of sovereign debt and bankruptcy, ones that might ultimately help construct a more effective global system.

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