Greece’s debt to GDP dilemma

Published 18th June 2015

Commentators, like the FT’s Martin Sandbu, have pointed out — and rightly — that requiring Greece to run fiscal surpluses is likely to lead to lower rates of GDP growth and, other things being equal, higher level of debt to GDP at a times when the bailout program are trying to return Greece to stability. The IMF’s chief economist Olivier Blanchard recently argued that a deal between Greece and its Eurozone partners would be possible — and desirable — if only Greece were to agree to some reduction in pensions and the Eurozone Governments agreed to lower the demand for future fiscal surpluses i.e. to accept bigger bigger haircuts on the economic value of the outstanding debt. The FT has pleaded for someone — anyone — to concede on the basis that a default and Grexit would be harmful to the economic system as a whole.

But I wonder really if a deal along the lines that the IMF proposes would solve much. It is easy to see why the IMF would like to have a deal by the end of June that releases the funds that ensures that it gets paid in full and at par. The Americans and Europeans insisted on having another European head of the IMF after the departure of Dominique Strauss-Kahn in the face of stiff opposition from some non-Western members and in doing so used up some credibility. That credibility was further undermined with the massive and sweetened financial deals offered to Greece. If the money is not return in full and on time, the rest of the world will continue to set up parallel financial institutions like the Asian Infrastructure Investment Bank. Largarde is under pressure.

But what about Greece or the Eurozone? What is the level of haircut on Greece’s debt that would make the debt sustainable?

The first thing to observe is that although the nominal value of Greece’s outstanding debt appears to be over 180% of GDP, this debt is almost all on terms that Greece could not secure on an arms length basis. In other words, the fair value of the debt is below its nominal value and the debt to GDP is lower, perhaps a lot lower than 180%. By some measures, the economic debt to GDP ratio is Greece is lower than that of Italy, which currently stands at 135%.

But here we have a problem. What is the most appropriate discount rate to apply to the debt service payments? 
 
 Greek short rates — over 20% — are clearly unsustainable in the long term and cannot be used to discount these long term debt service payments. Another approach is to look at longer term euro interest rates and make an (upward) adjustment for the additional credit risks involved in lending to Greece. But doing this leaves us with the problem that the resulting interest rate still appears to be too high for any foreseeable level of Greek GDP growth, so ANY level of outstanding debt would rise unless the Greeks were to run fiscal surpluses — and that as noted above would depress GDP and exacerbate the problem. Yet another way to think about this is to look at the drivers of Greek GDP and ask what level of interest rate would be necessary to ensure that the debt did not spiral out of control as a percentage of GDP without having to run fiscal surpluses.

In the longer term, the main drivers of GDP growth are demographics and productivity — a point that Gavyn Davies emphasized in his recent FT article on the productivity conundrum (“Economists have always recognised that the long-run growth of productivity is, in the end, almost the only thing that matters for the living standards of the population as a whole”). We know that Greek workers work longer hours than most but that the total working age population is likely to decline — Greece — along with Italy and Germany — is one of the fastest ageing societies in Europe as I discussed in a previous post. That means unless there is reform to raise the working age, total labour hours that contribute to Greek GDP growth are likely to decline over the next decade. So there can be no expectation that Greece’s demographics will contribute positively to long term GDP growth and debt sustainability.

Turning to productivity growth, the other major driver of economic growth in the longer term, we see (OECD, Penn V 8.1) that Greece’s productivity growth has been very low, even taking into account high capital inputs before the crisis, because TFP growth has been very low or negative. At best one might expect, if trends are to continue and there is no reform, that productivity growth might be 0.1–0.2% per annum at best.

This suggests that the trend rate in GDP growth in Greece without reforms to improve productivity may be close to zero or even negative.
 
 That implies that the sustainable rate of interest for Greece may also be less than zero.

Of course the equilibrium rate of interest in the rest of the Eurozone is also lower than many had once thought and for the same reasons — demographics and lower expectations of productivity growth — but looked at in the round, it is hard to see that the trend growth rates in the Eurozone is likely to be less than 1% and with the kind of labour market and product market reforms that are already taking place in say Spain, France and Italy and which have already occurred in Germany, that trend growth rate may increase relative to Greece’s rather than reduce.

What does this imply for Greece?
 
 First, in my view, that a deal along the lines proposed by Olivier Blanchard by the end of the month only solves the problem facing the IMF, which is to get its money back at par, but it does solve the longer term problem facing Greece and the Eurozone.
 
 Secondly, even if the Eurozone were to forgive all of Greece’s debt, without reforms to enhance productivity — Greece would struggle within a Eurozone where long term interest rates were at say 1% and Greece’s trend GDP growth rate at 0%
 
 Third, while there is certainly an output gap, it is difficult to find a third party to finance it as long as Greece remains in the Eurozone without reform.
 
 None of this is to suggest that Greece has failed to make some reforms over the past 5 years. It clearly has as the Irish economist Karl Wheelan has argued. But the reality is that the kind of reform that needs to be undertaken, which I discussed previously, has barely begun.

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