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Trojan loans

The Troika’s overemphasis on austerity distracted attention from the reforms needed in Greece

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There were two other issues critical to the success of Greek macro adjustment. The immediate problem for Greece and other eurozone countries in danger of contagion was the absence of a normal central bank or lender of last resort.

The worst global crisis since the Great Depression, the “great recession”, hit the world in 2008. A number of high-income European countries, including Greece, were among the worst affected countries. The International Monetary Fund changed its rules to make loans to Greece that were more than 10 times the ratio limits applicable to loans made to developing countries during the previous 50 years. The only argument to make such an exception was to minimise the risk of contagion to other vulnerable European countries such as Portugal, Ireland and Spain. Then an IMF executive director, I pointed to the flaw in the economic analysis and projections underlying the Greek loan: “The scale of fiscal reduction without any monetary policy offset is unprecedented. [It] is a mammoth burden that the economy could hardly bear. Even if, arguably, the programme is successfully implemented, it could trigger a deflationary spiral of falling prices, falling employment, and falling fiscal revenues that could eventually undermine the programme itself. In this context, it is also necessary to ask if the magnitude of adjustment… is building in risk of programme failure and consequent payment standstill… There is concern that default/ restructuring is inevitable.”

Our experience of the Asian and Latin American crises had taught us that the domestic private and international sovereign debt overhang had to be dealt with quickly and effectively to stave off a “balance sheet recession” and give the economy a chance to recover. Further, that growth recovery depended critically on offsetting required government expenditure compression (austerity) by expenditure-switching (real depreciation and/ or monetary easing). Clearly, both the global demand situation and the domestic supply side had to be conducive to produce a sustained increase in net exports and investment to stimulate and sustain growth. In the absence of exchange-rate flexibility in Greece, austerity could only work by reducing the real wage rate. Given the deflationary post-crisis situation, austerity would reduce not just the nominal wage rate (w) but also the price level (p), thus having at best a small effect on the real wage rate (which is w/p). We concluded that restoration of Greek competitiveness within the eurozone would require a level of austerity that was socially and politically infeasible. We, therefore, argued that in Greece (and contagion candidates), the focus should be on fundamental fiscal (tax and expenditure) reform, which would put it on a sustainable fiscal path through a gradual reduction in expenditures and increase in tax ratios, which follow from such reform (for example, of pensions). Instead of an immediate reduction of government expenditure, the focus should be on limiting and reducing the growth of expenditures, perhaps in some cases to zero, and not on cutting everything drastically. The overemphasis of the Troika (Greece’s primary lenders — the IMF, European Central Bank and the European Commission) on “austerity” distracted attention from more fundamental fiscal and other economic reforms to increase competitiveness that still remain unimplemented by Greece.

There were two other issues critical to the success of Greek macro adjustment. The immediate problem for Greece and other eurozone countries in danger of contagion was the absence of a normal central bank or lender of last resort. The ECB was hemmed in by rules and constraints that kept it from acting like a normal central bank (like the Federal Reserve for the US,the Bank of England for the UK and the RBI for India). We argued that contagion couldn’t be stopped unless the ECB got complete freedom to lend to illiquid but solvent euro area banks and financial institutions (See “Averting A Euro Meltdown: Sharing Global Responsibility”, 2011). This problem was gradually solved after the appointment of Mario Draghi as the head of the ECB in November 2011, and the risks of contagion have been largely eliminated due to ECB empowerment and tightened financial regulation. However, subsequent to the No vote in the Greek referendum, the ECB has raised the collateral requirements for providing liquidity support to Greek banks. Greece is therefore effectively without a central bank to fulfil the lender of last resort function for its banks and payment system. If this support is not restored, Greece will have no option but to reintroduce its own currency and central bank.

The second important problem was Greece’s sovereign debt. It was clear to us in 2010 that Greek debt was unsustainably high, that is, there was no credible time path of nominal GDP growth that would result in a sustained and continuing decline in the debt-GDP ratio. Without a substantial restructuring of debt, resulting in an effective reduction in the present value of outstanding debt, any delay in debt reduction/ restructuring would worsen the debt problem. Thus, we argued that the IMF, euro and other sovereign loans would merely result in repayment to private lenders, and private debt would be substituted with public debt. Those who facilitated the Greek government’s profligacy would get away without bearing the consequences of their bad decisions or sharing in the pain of adjustment. This is precisely what happened. The debt crisis reappeared as predicted, and a partial debt write-off occurred in 2012, with a Troika-mediated agreement between private lenders and the Greek government. It was too little, too late. The debt-GDP ratio moved back to its earlier peak, triggering the loan default to the IMF and the latest crisis.

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The Greek crisis involves a mix of economic and political factors, and has thus created great uncertainty in the investing community. Normally such financial uncertainty leads to heightened liquidity needs in Europe, the sale of Indian equity and an outflow of capital and exchange rate depreciation. This time, there is an offsetting factor. If the crises slowed EU recovery, as is likely, the expected outflow of capital from India to the EU could be inverted. Thus, as I predicted, India could see a rise in equity markets cum capital inflow on one day, and the opposite another day, for the duration of the Greek crisis. From a medium-term perspective, a setback to EU recovery may also be a factor in the Federal Reserve’s decision on its quantitative easing programme in September, and effectively reduce the anticipated rise in interest rates.

The writer, a former executive director at the IMF, is an economic and public policy mentor