This is Part 3 of the “Relitigating 2010” series. It’s largely independent of Parts One and Two, although if you’ve literally only just starting reading about the issue, you might want to look at those ones first.
After a slight delay, this piece concludes my series on looking back on the 2010 bailout to see if things could have been done better. During that period, I’ve received a lot of interesting feedback on some of the points made, and it very much struck me that when I was responding to that feedback, there was always one common theme … see if you can spot it.
“The Greek banks didn’t have to be bailed out by borrowing money; they could have been recapitalised by the Greek government issuing new government bonds and giving them to the banks. This would have massively reduced the financing requirement you talk about in Part 2.”
Yes … but you have to remember that Trichet was in charge of the ECB at this point. Normally in a bank rescue, it’s not only orthodox to use newly created government bonds, it’s the sensible thing to do. (Banks don’t need cash, usually, so if you bail them out by issuing government bonds on the market and giving the cash to the banks, the first thing they will do with it is buy government bonds). But Euroland in 2010 was already at a point where the ECB was reluctant to accept Greek bond collateral. To have allowed the Greek government to first reduce its debt by defaulting, then blow it back out again by issuing around EUR50bn of new bonds to the banking system, would have required the co-operation of the ECB, which could not at all be relied upon.
“The dangers of contagion were greatly overstated. There’s no reason that a default would necessarily have led to a liquidity crisis.”
Well … you have to remember that Trichet was in charge of the ECB at this point. Jean-Claude Trichet did not, except possibly toward the very end of his term, recognise any responsibility of the ECB to maintain the stability of the financial system. He took an extremely restrictive view of the ECB’s mandate. Even the few moves that the ECB made toward providing emergency liquidity were justified in terms of monetary policy — they were rationalised as being necessary to allow policy to function. This wasn’t a post-LTRO environment in which central bank liquidity support could be assumed — for the longest time, Trichet-ECB saw bank liquidity as wholly a fiscal responsibility. Which makes no sense, of course; the fiscal system can’t swallow the monetary system, it’s not big enough.
“The correct thing to do would have been to let Greece default within the Euro, and make a clear statement of support for Spain”
But … was Trichet up for this? One of the most aggravating things about the crisis in 2010 was the refusal of the ECB to make a clear statement to the effect that the Euro was indivisible, and that it had responsibility to preserve the Euro with its membership intact. The form of words they kept using was that the ECB had “a strong preference” for Greece to remain in the Euro, which was correctly seen by the market as less than total commitment (imagine if your spouse told you they had a “strong preference” for staying married). The doctrine of “we will do whatever it takes” was introduced by Draghi, later, and it had a huge effect for precisely this reason. Under Trichet-ECB, the view was “we will do whatever we feel comfortable with”.
Sooo, it’s clear that the list of “whose fault was it all?” is going to have one name written on it early on, in indelible ink. The crisis of 2010 was written into the system as it was designed in 1999; lots of people said so at the time and although it was a shock when it came, it shouldn’t have been a surprise. But central bankers are judged by how they respond to crisis, and Trichet didn’t respond at all. Although his view of the ECB’s role and duties makes a certain kind of legalistic sense, the ECB actually has very considerable power to define its own role, and to make things work. Mario Draghi, since he took over, has proved that. Draghi has also shown that a President of the ECB who is prepared to take power into his own hands can get things done and can draw the rest of the Governing Council in to follow him. So although Axel Weber also deserves a certain amount of the blame, I don’t think it’s a realistic defence of Trichet to say that his hands were tied by the Bundesbank.
This is, in my view, one of the reasons why English and American commentators consistently got things wrong in analysing Europe in the early stages of the crisis. They’re tempted to analyse things through the prism of their own experiences, and the crisis in the UK and USA was experienced entirely in policy terms as a fiscal authority consistently screwing things up, while the monetary authorities did their best to unscrew them. That’s not what happened in the peripheral European crisis. As we’ll discuss in the next section, the fiscal authorities did as much as was humanly possible and then a little bit more, while the monetary side fell asleep on the job.
Was there a policy of austerity?
This is the key to understanding the 2010 bailout and its aftermath, in my view. Nearly all the discussion of the program is still couched in terms of the Greek budget cuts as a policy — the proverbial “failed policy of austerity”. But as far as I can see, this isn’t true. Not because there was no austerity, but because there was no policy.
Calling something a “policy” surely implies that there was any choice to be made. Japan doesn’t have a pro-earthquake policy, and Ireland doesn’t have a policy of helping the farmers by making it rain all the time. More relevantly, if you’ve got a hard budget constraint, because nobody will lend you money except the troika, and the troika have more than maxed out their ability to lend to you, then this isn’t a policy of austerity — your primary budget balance is determined by the budget constraint, and setting that aggregate level of spending rather than a higher one is just a recognition of reality. The decision to stay in the Euro rather than leaving it was a policy, and the decision co-operate with the troika rather than defaulting was a policy. But once those two decisions have been made, that’s all the policy that there was.
For this reason, I think it’s hard to put any of the Eurogroup heads of government on the list of infamy. As we saw in Part 2, there might possibly have been really imaginative solutions based on having Greece default on private sector debt which might have either reduced the funding requirement, or made the same amount of funding work harder for Greece. But all of these solutions, as far as I can see, would have made the domestic politics even worse than they actually were, and would have required the Eurozone financial system to rely very heavily on ECB support which couldn’t be relied on. I don’t see myself wanting to blame Merkel or Hollande for not taking this massive gamble.
(Another reason not to blame Francois Hollande, as pointed out by Jerome Druesne in a comment, is that he wasn’t actually President of France at the time, Sarkozy was. Apologies for this and other sloppy errors of drafting …)
Why was the budget constraint so hard?
But although the political budget constraint was there, and needs to be taken into account, we should shouldn’t treat political decisions as being wholly unalterable facts of nature. This would be where we start adding names in the Eurozone finance ministries to the roll of blame. Recall that, as discussed in Part 2, the Greek bailout package can be analysed into three main components:
1) A large bank bailout for the Greek banking system (about EUR50bn)
2) A comparatively rather small package of fiscal deficit financing for Greece (about EUR16bn)
3) An agreement on the part of the Eurogroup to assume the Greek sovereign debt and restructure it at a later date (About EUR200bn)
The biggest up-front component of the package, component 1), was made much larger than it needed to be, because of fears that the ECB wouldn’t do its job properly. To a large extent, component 3) was also larger than it might otherwise have been for the same reason — nobody wanted to take the risks associated with the alternative course of defaulting on privately-owned sovereign debt, also largely out of fear that the ECB wouldn’t do its job properly.
But these two issue were compounded by yet another mistake — the failure on the part of the Eurogroup to see that a larger up front investment in component 2) would most likely significantly reduce their exposure in component 3). Or to put it more simply, a Keynesian stimulus, or more mitigation of the government spending crunch that actually took place, would make it easier for Greece to service its debt in the long term, improve its ability to get back to market financing, and make the long term losses to its creditors smaller.
Why did they miss this? Because they didn’t believe that they could politically sell a solution based on Keynesian stimulus.
Don’t look so smug. Remember that even Larry Summers, who surely wasn’t confused on the economics, put forward a stimulus budget half the size of the one the USA needed in 2009. He refused to allow Christina Romer’s properly-sized proposal to even be suggested to the President, because he believed it to be a political impossibility to get it through Congress. The UK spent several years concentrating on deficit reduction as its primary goal. The fact is — and all of us in the economics profession need to look in the mirror a bit about this and ask ourselves why we have done such a bad job — it isn’t easy, anywhere in the world, to build and sustain a political case for Keynesian stimulus.
The evidence seems to be that at best, you can get support when everyone is terrified about the imminent end of civilisation — as Robert Lucas said, “we are all Keynesians in a foxhole”. But as soon as the moment of greatest terror is passed, analogies to household finances start creeping back again and proponents of expansionary austerity and structural reform start getting a hearing. This doesn’t look to me like a specific pathology of Euroland — it looks like a general popular idiocy of the 21st century, of which the Eurozone happened to have a particularly severe and disastrous case.
Of course, the reason why Europe had it so bad was that the institutions and rules of the Euro had been set up specifically on anti-Keynesian lines; this is another mistake that was made before 1999. They were set up partly as they were because as a rule, influential people don’t believe in Keynesian economics when there isn’t a crisis on, and partly because the nations of the Eurozone didn’t trust each other, and so preferred to deal with the issue of financing any necessary stimulus by looking the other way and pretending that no such problem could ever occur.
Lending and control
Also, there was decent reason to believe that the multiplier on fiscal stimulus in Greece in 2010 might be very low indeed. If government deficits were financing capital flight, and if Greek citizens had reason to hoard euros, then the marginal propensities to import and to save might be much higher than in normal recessionary conditions. And given the state of the Greek government’s ability to collect taxes, any positive effect of a stimulus program might have a significantly attenuated positive effect on the government finances. So the “win-win” argument that a more generous up front package could have reduced the amount of debt that eventually needed to be assumed isn’t necessarily as obviously correct as it looks on paper. There would certainly have been no guarantee that conditions in Greece wouldn’t still have got bad enough to bring a government to power which intended to default and/or leave the Euro. The credit risk which the core Eurozone countries were taking was pretty substantial.
Given that, they needed tools to manage that risk. And as I have noted in several previous posts, in an environment where there are no real governance arrangements, one way in which lenders exert control over borrowers is by ensuring frequent roll-overs of debt. A big up-front stimulus package would have given away most of this leverage. As it happens, most of the leverage that the troika had was more or less roundly abused; they didn’t really concentrate on making sure measures would be taken which increased their ability to get paid back in the long term, they wasted it on irrelevant hobby-horses of structural reform and on the IMF’s institutional horror and moral outrage at the idea that somebody, somewhere, might be retiring comfortably on a state pension.
But for all of the very legitimate criticisms of the way in which the troika’s power was used, this is the key reason why a larger up-front program was never a politically realistic option. Nobody was going to agree a program which didn’t include regular high-stakes program reviews and debt rollovers, for roughly the same reason that you don’t write a blank cheque to a landscape gardener or enable in-app purchases on your daughter’s iPhone. That reason being, that nobody in their right mind is going to agree to limitless underwriting of a liability over which they don’t have close control. The Eurozone probably wouldn’t have agreed to those sorts of terms for Sweden, Luxembourg or any other high-trust economy, let alone the lowest-trust society in Europe.
So in my view, the kind of win-win/front-loaded program which the critics of 2010 advocate is a bit of a mirage. In principle the solution was there, but in order to get to it, you would have to wish huge political problems out of existence. And if you had that kind of political superpower, you might better have used it on getting the ECB statutes rewritten to get rid of the massive deflationary bias in them.
My ultimate conclusion, then, is that the 2010 Greek bailout program was the very natural outcome of a highly risk-averse set of Eurozone politicians and civil servants, working as hard as they possibly could under extraordinary constraints. They pushed the political envelope as far as they could have been expected to and further, and came up with a solution which would certainly have been rejected by creditor-country voters if it had ever been exposed to a referendum. And the situation in which they had to do this was largely created by an ECB which, at the time, was interpreting its mandate incredibly narrowly and asking fiscal funding to perform an essentially monetary role. The damage done to the Greek economy was done by the conditionality, not the debt, and the conditionality for the period 2010–2013 was largely determined by a genuine budget constraint rather than any intentional policy on anyone’s part. It was neither a cock-up nor a conspiracy — it was a natural consequence of what happens when a fundamentally anti-Keynesian set of rules and institutions has to deal with a fundamentally Keynesian crisis.