Merkel, Greece and the eurozone: another haircut?

by George Hatjoullis

Angela Merkel has announced that Greece should never have been allowed to join the eurozone ( This remarkably unremarkable statement no doubt is deemed helpful to her election campaign. It is also somewhat disingenuous. The eurozone initiative, indeed the wider EU structure, is a political project with economic costs. It always has been so and all involved have understood it to be such. No one ever thought Greece was economically ready to join the eurozone but political imperatives over-rode such considerations. The big surprise was how much this political decision was going to cost.

Debt-to-GDP ratio in Europe. Up to current yea...

Debt-to-GDP ratio in Europe. Up to current year. Older versions: see file history below. (Photo credit: Wikipedia)

In part this was the fault of the eurozone policy makers. The markets started to price all eurozone sovereign debt as if it were somehow jointly guaranteed by all eurozone members. Such joint-guarantees are explicitly prohibited in the Maastricht Treaty so quite why the market came to this conclusion is a mystery. The real problem however was that the eurozone authorities failed to see the moral hazard risk in this market misunderstanding and did nothing to adjust market perceptions or amend the Treaty. Greece compounded the problem by taking the moral hazard to the limit by cooking the books. Its national accounts were largely a fabrication which the Brussels jobs-worths failed to notice until it was too late. The reason the IMF became involved in a european crisis response is precisely because Berlin ceased to have any faith in the Brussels jobs-worths!

The Berlin response was to place moral hazard at the heart of all crisis response measures. It was not about punishing miscreants. It was about making sure abuse of eurozone membership was no longer possible. The first step was to make sure all member states faced up to their obligations. Unfortunately some member states, notably Greece, could not meet their obligations under any reasonable conditions. A contorted and reactive crisis management programme was the result.

Greece has in some ways been better treated than other states. Greece was allowed to haircut some sovereign debt which constituted a subsidy from the debt holders to Greece. The eurozone has also made Greece large loans at preferential interest rates subject to Greece meeting some strict conditions. The result is that the Greek sovereign debt position today is circa 160% of GDP. Is this a sustainable debt position for Greece?

Any debt level is arithmetically sustainable. All that is required is that Greece achieve a primary fiscal balance equal to its interest bill on the debt, forever. If the debt also grows no faster than GDP then the debt-to-GDP ratio is stable to declining. Simples! Well not quite. Greek GDP is presently falling at a rate of over 4% per annum. It is quite hard to sustain a primary surplus when GDP is contracting as revenue is falling and expenditure not so much.

The solution, according to the troika, is for asset sales and structural reform in Greece. The net effect of asset sales is controversial if they were generating revenue or eliminating expenditure. The implication is that the foregone revenue ( consequent additional expenditure) is less than the interest saved. Structural reform is clearly beneficial (and very necessary) in Greece as it can raise the revenue generated for a given level of GDP and reduce expenditure, especially by its bloated and inefficient public sector. However, such reform is meeting social and political resistance and taking longer to implement than is required. It is unlikely that it will start to offset the negative effects of the negative growth for a while.

Greece will need positive GDP growth in excess of debt growth for a sustained period  in order to reduce the debt-to-GDP ratio whilst maintaining a primary fiscal balance that at least covers debt servicing. This is a challenging ask and not one that Greece is obviously capable of achieving. There is already talk of Greece requiring an additional 10 billion euro or so of official low-interest loans from the troika.

Only an optimist would assume that Greece will ever get this debt-to-GDP ratio down to what is deemed sustainable (120% ?) without some help from Mount Olympus. The risk that a further haircut on outstanding Greek debt will be forthcoming is high. The bulk of this debt is held by official institutions and will thus constitute an official subsidy. This may not even be legal under the Maastricht Treaty and no doubt the German Constitutional court will be called into action in such circumstances. It may also raise some issues in other crisis states. Merkel has been adamant that there will not be another haircut on Greek debt and no doubt these are the reasons. However, the arithmetic does not really stack up. Moreover, the consequences of a haircut may not be easily contained by the ECB (so far saviour of the eurozone). Watch this space.