The Euro Zone’s Default Position

WASHINGTON, DC – Kazakhstan may be far removed from the euro zone, but its recent economic experiences are highly relevant to the euro’s current travails. As the euro zone struggles with debt crises and austerity in its weaker members, Kazakhstan is emerging from a massive banking-system collapse with a strong economic recovery. For most of the last decade, Kazakhstan gorged on profligate lending, courtesy of global banks – just like much of southern Europe. The foreign borrowing of Kazakh banks amounted to around 50% of GDP, with many of these funds used for construction projects. As the money rolled in, wages rose, real-estate prices reached to near-Parisian levels, and people fooled themselves into thinking that Kazakhstan had become Asia’s latest tiger. The party came to a crashing halt in 2009, when two sharp-elbowed global investment banks accelerated loan repayments – hoping to get their money back. The Kazakh government, which had been scrambling to support its overextended private banks with capital injections and nationalizations, gave up and decided to pull the plug. The banks defaulted on their loans, and creditors took large “haircuts” (reductions in principal value). But – and here’s the point – with its debts written off, the banking system is now recapitalized and able to support economic growth. Despite a messy default, this fresh start has generated a remarkable turnaround. The West European approach to dealing with crazed banks is quite different. Ireland, Europe’s (Celtic) tiger over the last decade, grew in part due to large credit inflows into its “Banking Real Estate Complex.” The Irish banking system’s external borrowing reached roughly 100% of GDP – two Kazakhstans. When the world economy dove in 2008-2009, Ireland’s party was also over. But here’s where the stories diverge, at least so far. Instead of making the creditors of private banks take haircuts, the Irish government chose to transfer the entire debt burden onto taxpayers. The government is running budget deficits of 10% of GDP, despite having cut public-sector wages, and now plans further cuts to service failed banks’ debt. Greece is now at a crossroads similar to that of Kazakhstan and Ireland: the government borrowed heavily for the last decade and squandered the money on a bloated (and unionized) public sector (rather than modern – and vacant – real estate), with government debt approaching 150% of GDP. The arithmetic is simply horrible. If Greece is to start paying just the interest on its debt – rather than rolling it into new loans – by 2011 the government would need to run a primary budget surplus (i.e., excluding interest payments) of nearly 10% of GDP. This would require roughly another 14% of GDP in spending cuts and revenue measures, ranking it among the largest fiscal adjustments ever attempted. Worse still, these large interest payments will mostly be going to Germany and France, thus further removing income from the Greek economy. If Greece is ever to repay some of this debt, it will need a drastic austerity program lasting decades. Such a program would cause Greek GDP to fall far more than Ireland’s sharp decline to date. Moreover, Greek public workers should expect massive pay cuts, which, in Greece’s poisonous political climate is a sure route to dangerous levels of civil strife and violence. European leaders are wrong if they believe that Greece can achieve a solution through a resumption of normal market lending. Greece simply cannot afford to repay its debt at interest rates that reflect the inherent risk. The only means to refinance Greece’s debt at an affordable level would be to grant long-term, subsidized loans that ultimately would cover a large part of the liabilities coming due in the next 3-5 years. And, even on such generous terms, Greece would probably need a daunting 10%-of-GDP fiscal adjustment just to return to a more stable debt path. The alternative for Greece is to manage its default in an orderly manner. Reckless lending to the Greek state was based on European creditors’ terrible decision-making. Default teaches creditors – and their governments – a lesson, just as it does the debtors: mistakes cost money, and your mistakes are your own. With each passing day, it becomes more apparent that a restructuring of Greek debt is unavoidable. Some form of default will almost surely be forced upon Greece, and this may be the most preferable alternative. A default would be painful – but so would any other solution. And default with an “orderly” restructuring would instantly set Greece’s finances on a sustainable path. After tough negotiations, the government and its creditors would probably eventually slash Greece’s debt in half. Greek banks would need to be recapitalized, but then they could make new loans again. A default would also appropriately place part of the costs of Greece’s borrowing spree on creditors. The Germans and French would need to inject new capital into their banks (perhaps finally becoming open to tighter regulation to prevent this from happening again), and the whole world would become more wary about lending to profligate sovereigns. Ultimately, by teaching creditors a necessary lesson, a default within the euro zone might actually turn out to be a key step toward creating a healthier European – and global – financial system. Simon Johnson, a professor at MIT’s Sloan School of Management, a senior fellow at the Peterson Institute, and former chief economist of the IMF, is co-author of the forthcoming book 13 Bankers. Peter Boone, Chairman of Effective Intervention at the London School of Economics’ Center for Economic Performance, is a principal in Salute Capital Management Ltd. Copyright: Project Syndicate, 2010. www.project-syndicate.org For a podcast of this commentary in English, please use this link: http://media.blubrry.com/ps/media.libsyn.com/media/ps/johnson6.mp3

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The Euro Zone’s Default Position