Excerpted from Michael Pettis' China Financial Markets blog, [21]
Syriza’s challenge
It is useful to remember this history when we confront the consequences of Greece’s recent elections. Syriza’s victory in Greece has reignited the name-calling and moralizing that has characterized much of the discussion on peripheral Europe’s unsustainable debt burden. I think it is pretty clear, and obvious to almost everyone, that Greece simply cannot repay its external obligations, and one way or another it is going to receive substantial debt forgiveness. There isn’t even much pretence at this point as last week's German newspaper Zeit‘s interview [22] with Yanis Varoufakis entitled “I’m the Finance Minister of a Bankrupt Country” shows.
Even if the question of who is to “blame”, Greece or Germany, were an important one, the answer would not change the debt dynamics. It would take the equivalent of Ceausescu’s brutal austerity policies in Romania, which were imposed during the 1980s in order for the country fully to repay its external debt, to resolve the Greek debt burden without a write-down. Given that Ceausescu’s policies led directly to the 1989 revolution, which culminated in both Ceausescu and his wife being executed by firing squad, the reluctance in Athens to imitate Romania in the 1980s is probably not surprising.
But to say Greece simply cannot repay isn’t the end of the story. As Europe moves towards a more rational debt policy with Greece, I would say that there are three important things to remember:
1. There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost.
I think most analysts understand that costs will rise during the restructuring process. I am not sure they understand, however, that delays will impose even heavier costs during the many years of subsequent adjustment. There is a lot of bad blood and recrimination among the various parties. I suspect that some of those who oppose Syriza are probably revolted by the thought that a rapid resolution of the Greek crisis would rebound to Syriza’s credit, but they must understand that dragging out the restructuring process will impose far greater long-term costs on the Greek people than they think.
My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume.
2. From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents.
There are at least two important functions of an economic entity’s liability structure. One is to determine the way operating profits or economic growth is distributed among the various stakeholders, or, put differently, to determine economic incentive structures. The other is to determine the way external shocks are absorbed. This is why the restructuring process is so important and can determine subsequent economic growth. The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems). Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashfllows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.
3. In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests, largely becausse these instruments have not been “invented”. Among other things the negotiating committee might want to dust off the GDP warrants that were included in Argentina’s last debt restructuring.
If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor. I was delighted to see that Greece’s new Finance minister agrees. An article [23] in Monday’s Financial Times starts with the claim that “Greece’s radical new government revealed proposals on Monday for ending the confrontation with its creditors by swapping outstanding debt for new growth-linked bonds, running a permanent budget surplus and targeting wealthy tax-evaders.” Today’s Financial Times has an article [24] by Martin Wolf that mentions the benefits of “a growth linked bond”. In The Volatility Machine I spend chapters explaining how to create liability structures that minimize external shocks, align the interests of creditors and citizens, and improve the quality of payments for creditors, and I show why these make a restructuring much more successful for all parties concerned. This is just basic finance theory. Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.
Enough people seem to hate or fear Syriza that there will be little attempt to approach Greece’s problems with enough imagination to give either party what it needs, but in fact with the right cooperation, imagination, and intuitive understanding of how balance sheet structures change overall value creation, a Greek debt restructuring could leave both sides far better off than either side might imagine. Of course if done right this matters far more than for just its impact on the Greek economy. While everyone probably agrees that Greece simply cannot proceed without debt forgiveness, less widely agreed, but no less obvious in my opinion, is that there are a number of other European countries that also need debt forgiveness if they are to grow. Because I was born and grew up in Spain, and my French mother founded and ran a successful business there which my family and I still own, I am confident that I know the country well enough to say that even with some impressive reforms having been implemented under Mariano Rajoy, Spain is nonetheless one of these countries. I suspect that many other countries including Portugal, Italy, and maybe even France are too.
I also know, however, that Spanish debt prospects are an extremely sensitive and emotional topic, and I will be roundly condemned for saying this. Today’s Financial Times has a very worrying article [25] explaining why Madrid wants to be seen among the hardliners in opposing a rational treatment for Greece: “when it comes to helping Greece, there will be no such thing as southern solidarity or peripheral patronage.” This is the reverse of what it should be doing. In an article [26] for Politica Exterior in January 2012, I actually proposed, albeit without much hope, that Spain take the lead and organize the debtor countries to negotiate a sustainable agreement, but in its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the “virtuous” countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter.
As it is, and for reasons that may have to do with recent history, Francisco Franco, and the psychological scars he left among those of my generation, any discussion in Spain is likely to be subsumed under non-economic considerations, especially angry denunciations of moral virtue and moral turpitude. These non-economic considerations are irrelevant. In fact some of them are very important and even admirable. But they must be understood within a more neutral context.
As far as I can tell there are at least four important reasons that opponents of debt forgiveness, not just in Germany but also in Spain, have proposed as to why demands for debt forgiveness would be a long-term disaster for Spain:
1. Spain’s economic future depends on its remaining a member of Europe in good standing. To demand debt forgiveness (let alone a renegotiation of the currency union) would cause a financial crisis and relegate Spain to backward country status.
2. If Spain fails to honor its debt commitments it will be considered forever an unreliable prospect and will be frozen out of future investment and trade.
3. More importantly, it would be morally wrong. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity.
4. Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless invest projects. It got itself into this mess only because of the very poor economic policies a corrupt Madrid implemented. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of tis leaders, but ultimately they are responsible.
These four arguments, which are the same arguments made about other highly indebted European countries, have been made not just by the greedy Germans of caricature, but also, more importantly, by indignant locals. They genuinely believe that their country behaved stupidly and must pay the price, and it is hard not to respect their sincerity.
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In summary, I think there are several points that those of us who want “Europe” to survive should be making.
1. The euro crisis is a crisis of Europe, not of European countries. It is not a conflict between Germany and Spain (and I use these two countries to represent every European country on one side or the other of the boom) about who should be deemed irresponsible, and so should absorb the enormous costs of nearly a decade of mismanagement. There was plenty of irresponsible behavior in every country, and it is absurd to think that if German and Spanish banks were pouring nearly unlimited amounts of money into countries at extremely low or even negative real interest rates, especially once these initial inflows had set off stock market and real estate booms, that there was any chance that these countries would not respond in the way every country in history, including Germany in the 1870s and in the 1920s, had responded under similar conditions.
2. The “losers” in this system have been German and Spanish workers, until now, and German and Spanish middle class savers and taxpayers in the future as European banks are directly or indirectly bailed out. The winners have been banks, owners of assets, and business owners, mainly in Germany, whose profits were much higher during the last decade than they could possibly have been otherwise
3. In fact, the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history, in that it pits the interests of workers and small producers against the interests of bankers. The former want higher wages and rapid economic growth. The latter want to protect the value of the currency and the sanctity of debt.
4. I am not smart enough to say with any confidence that one side or the other is right. There have been cases in history in which the bankers were probably right, and cases in which the workers were probably right. I can say, however, that the historical precedents suggest two very obvious things:
First, as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths. One path involves many, many more years of economic hell, as ordinary households are slowly forced to absorb the costs of debt — sometimes explicitly but usually implicitly in the form of financial repression, unemployment, and debt monetization. The other path is a swift resolution of the debt as it is restructured and partially forgiven in a disruptive but short process, after which growth will return and almost certainly with vigor.
Second, it is the responsibility of the leading centrist parties to recognize the options explicitly. If they do not, extremist parties either of the right or the left will take control of the debate, and convert what is a conflict between different economic sectors into a nationalist conflict or a class conflict. If the former win, it will spell the end of the grand European experiment.
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