Ed: At this critical moment for the European project, we have the honour to present a special guest contribution from Norman Strong, who has agreed in the light of the extreme circumstances we are facing to finally resume the occasional series of posts he began here in 2002. Like Duke Nukem Forever and the Stone Roses’ second album, it’s been a while.
The first thing to note is that there is, despite appearances, no urgency. Once one has accepted the fact that a restructuring of Greek debt will be needed, then it is no longer the case that “kicking the can down the road” will “only make things worse in the long run”.
Some simple arithmetic, from the point of view of Greece:
Say that the total sustainable debt burden of Greece is X, while its current debt burden is Y. If we were to reschedule tomorrow, the necessary markdown percentage would be X/Y.
But if we don’t reschedule tomorrow, and instead lend an extra amount Z, then the sustainable burden doesn’t change â€“ the eventual writedown will now just be X/(Y+Z).
In other words, new net lending to Greece, from the EU, IMF and/or EFSF to finance the current deficit, is just pushing down the eventual recovery rate on all debt. The marginal rate of writedown on new credit extended to Greece is one hundred per cent. It is effectively a fiscal transfer, financed by either a tax on all bondholders (if the new debt goes in pari passu), a tax on pre-crisis bondholders (if the new debt were to go in on a senior basis), or a tax on the official sector (if the new debt is wholly or partially financing an exit at par for pre-crisis bondholders as they redeem). The Greek government should be trying to borrow as much as anyone will lend them, since the repayment terms don’t matter if you’re planning to default. It is analogous to the practice of “trading while insolvent” for a company; this is an illegal thing to do for a corporation, but countries aren’t corporations.
With that in mind, we realise we are under no time constraint at all, and we can organise the eventual bailout at our leisure and for our political convenience. Particularly, we can stick it out past 2013, by which time the German Presidential elections will be out of the way, and a raft of new European legislation will be in place with respect to sovereign and bank debt restructuring, allowing the whole business to be carried out on a more civilised basis.
(Academic economists and bond traders alike, by the way, always underestimate the need for legal certainty, while policymakers never do. Much avoidable misunderstanding results from this, and from the fact that I have never seen a “plan to save the world” from either an economist or a bond investor, no matter how otherwise sensible, which didn’t have a giant great lacuna in the middle where anyone with policy experience would immediately say “that’s the bit where a thousand lawyers suddenly pop out of the woodwork and start arguing with each other, resulting in something absolutely critical not getting done”.)
So with time on our side, and no real intention of doing anything until we have as much legal and political certainty as we need, what would be the least painful way to achieve our end? I am assuming that our objective here is to get Greece back to a sustainable fiscal position, without destroying the Eurozone banking system on the way, with as little pain as possible. That is the plan, isn’t it guys? I assume so, but I am often reminded of Enron’s legendary fixer, John Wing and his cry of “Everyone trying to do this deal, that side of the room â€“ everyone trying to screw it up, over there!”. the easy way to do this is by using the equipment provided; a central bank. The ECB currently owns EUR62bn of Greek government bonds outright, via the Securities Market Purchase program. There is also a substantial debit balance on the part of the Bank of Greece at the ECB, reflecting payment imbalances in the Eurosystem. This is not a fiscal exposure (the Greek government has no use of the proceeds and the debt is collateralised). But if need be, it could be converted into one; one would only need the Greek banking system to sell their collateral to the ECB in an extension of the SMPP.
The only point I’m trying to make here is that, in stage 1 of my plan, I can get the ECB into a position where it is as big or as small a creditor of the Greek state as it needs to be. (Stage zero, helas, involves getting Greece to a position of primary fiscal surplus, and that is going to hurt. Fundamentally, fifteen years ago, Greece faced a choice between being the kind of country that doesn’t collect taxes on the middle and upper class, or the kind of country that pays generous benefits and public sector salaries, and chose both. There is no financial whizzkid trick in the world that will let you get over that one).
But my flexibility in making the ECB the largest creditor in stage 1 is important, because stage 2 involves the EFSF providing a special loan facility for the Hellenic Republic to make an open market tender offer for its outstanding bonds at a discount to face value. My guess is that few private-sector holders would tender into such an offer, but the ECB certainly could, as long as it was given an indemnity for the costs of doing so by its shareholders. The ECB actually holds a substantial proportion of its GGBs at a significant discount to face in any case, as it bought them in the market, while any further transactions would take place at current market price, so the indemnity would not necessarily need to be huge. In actual fact, the ECB could do this solo, without any indemnity â€“ the losses would wipe out its capital, but under the ECB treaty, this would immediately be replaced by its shareholders (the fiscal authorities of Euroland) in proportion to their holdings of the ECB’s initial capital. But that would be an example of the kind of “bright idea with an obvious legal black hole” I was talking about earlier, whereas the provision of fiscal indemnities for central bank rescue operations is very orthodox practice.
What about “private sector participation”? Well, the private sector would have already participated in this one, by crystallising their mark-to-market losses on sale of their bonds to the ECB. It is true that the scale of private sector participation might be less in total than one might wish (as the market price would presumably rally if the ECB were a large buyer), and certain kinds of unpopular players like vulture funds might not bear as much of the burden as policymakers might wish. But if you don’t like this, Euroland, then remember that you have the power to tax. There are all manner of fiscal instruments that can be used to equalise and spread the pain about â€“ the ratings agencies would presumably regard such fiscal rough justice as equivalent to a selective default, but come on â€“ you didn’t really think we were going to get out of this without defaulting, did you?
The idea is so simple (as JK Galbraith said about the creation of money in a fractional reserve banking system) that it repels the mind. To repeat â€“ all we need is the existing Euro, the existing EFSF, and a legal opinion that this would not constitute monetisation of the Greek national debt, which as far as I can see it wouldn’t. But there is no rush.