Greece Is Still Trapped

Paul Krugman has written a widely read blog post that appears to have gotten many people excited about the potential for bounce-back growth in Greece by reversing austerity. I’m here to rain on that parade.

Krugman figures that if Greece could get permission from its creditors to reduce its primary surplus to zero from the 4.5% of GDP that it’s supposed to run, it could boost its GDP by 12% and reduce unemployment by 10 percentage points. The math involves multipliers, which you may or may not agree with, but that’s not the point of this post.

The problem is that Greece doesn't have that 4.5% primary surplus. That's a target that it was supposed to reach in 2016, according to the previous government’s last fiscal agreements with the EU and IMF, published last April and May. The target for this year was a primary surplus of 3% of GDP, and the target for 2014 was 1.5%.

The actual primary surplus in 2014 was a smidgen over 1% of GDP, or €1.87b, according to the Greek finance ministry’s latest budget report. (UPDATE: By the IMF’s count Greece had zero primary surplus. See my more recent post.) In other words, although Greece has implemented quite a lot of austerity since 2010, it’s not generating some big cash surplus that could be spent on fiscal stimulus if the burden of debt service were lifted.

What’s more, that improvement in the primary surplus to 4.5% of GDP by 2016 was supposed to come not from more austerity, but from a recovery of nominal GDP, which the EU and IMF agreed should bounce back from a small 0.1% contraction in 2014 to grow by 3.3% this year and 4.9% in 2016. So far that’s not working out, as a slight rebound of real growth has been overwhelmed by deflation: nominal GDP contracted by 2.3% year-on-year in the first three quarters of 2014.

So let’s map out a couple scenarios, and see how the numbers actually add up.

Scenario 1: No Default, Maximum Creditor Leniency

Imagine that somehow Greece’s NGDP really does bounce back, and roughly matches the optimistic trajectory charted by the EU and IMF. Imagine the EU and IMF agree to refinance all of Greece’s debts that fall due through 2016, European central banks agree to continue reimbursing to Greece the interest payments on the Greek debts they hold, and all they ask of Greece is to finance its own outlays and other interest payments.

According to the April EU report, Greece is due to repay about €11.7b to the IMF in 2015-2016, of which the IMF is already planning to roll over about €9b (using dated exchange rates). So the IMF would have to agree to roll over that other €2.7b.

Greece is due to repay €15.6b of private debts, repos and arrears in 2015-2016, not counting short-term treasury bills and other domestic credit to the government that the EU and IMF assumed will be rolled over. Of that, €5.6b was supposed to be covered by privatization sales and the other €10b was left to be negotiated. Privatization receipts came to €0.4b last year. Never mind, let’s assume the rest of Europe agrees to roll over that whole €15.6b into multi-decade loans with deferred, near-zero interest.

So then Greece would only need to run enough of a primary surplus to cover the interest owed to creditors that aren't deferring or reimbursing it. Those are surprisingly low. Gross interest payments in 2014 came to €5.57b according to the finance ministry budget report. But a large portion of that goes to the ECB and Euro Area national central banks, which have a standing agreement to reimburse it right back to the Greek government. Those reimbursements were expected to come to €2.5b in 2014, as estimated in the EU’s April report (labeled “ANFA & SMP profits” in Table 11).

That works out to €3.07b of net interest costs or just 1.7% of GDP. The EU estimated Greece’s net debt service costs would drop to 1.6% of GDP in 2015 and rise to 1.9% of GDP in 2016.

So if the growth trajectory is enough to generate primary surpluses of 3% and 4.5% in 2015 and 2016, then in this scenario the Tsipras government could instead run primary surpluses of 1.6% and 1.9% and spend 1.4% of GDP in 2015 and 2.6% of GDP in 2016 on fiscal stimulus. That’s a lot of growth optimism and a lot of creditor leniency for not so much stimulus after all. Krugman’s rosy scenario isn’t just extremely rosy, it’s completely impossible.

But what if the growth rebound doesn’t work out, or if real growth happens but continues to be canceled out by deflation? Then there’s no room for any fiscal stimulus, even with the very high degree of creditor leniency I’ve described. If nominal GDP continues to contract, creditors will demand more austerity.

Note that I’m not factoring in any potential write-downs of the principal of Greek debts. Those aren’t actually important to cash flows, as long as creditors keep rolling over and extending the debts.

Scenario 2: Default

With a primary surplus, even a small one of 1% of GDP, it might seem in Greece’s favor to strategically default. But dig into the details and it turns out not to be so.

Greece has basically four creditor groups that it needs to make payments to in 2015-2016. One of the biggest and by far the most prickly is the European Central Bank and Euro Area national central banks, also called the Eurosystem. Because it's the backbone of the euro and any losses it takes fall directly on Euro Area taxpayers, the Eurosystem was exempted from the 2012 restructuring of Greek government bonds, which involved swapping old bonds for less valuable, longer-dated ones. So the Eurosystem holds the vast majority of the bonds that fall due in 2015-2016, which total €9.8b according to the April EU report.

Defaulting on partner central banks within a currency union would be a totally unprecedented step with unpredictable consequences. I figure no small number of lawyers around the EU are deep in the law books right now trying to trace all the possible outcomes. I have no idea. But these are not your ordinary creditors. These are the people who make the currency.

Many writers assume Greece would somehow be expelled from the currency union or from the EU itself, but one thing I do know is that there’s absolutely no legal way to do either of those things. Perhaps the ECB could do something really mean and annoying, such as stop processing interbank transfers into or out of Greece, to try to pressure Greece into either paying up or quitting the euro. The ECB could perhaps issue irritatingly restrictive orders to the Bank of Greece, but given the European system of self-enforcement, that might not be a good idea.

The biggest chunk of repayments in 2015-2016 are due to the IMF, which as I explained above is owed about €11.7b and has already agreed to roll over about €9b. As a rule the IMF never forgives debt, and I don't see it making an exception for one of its wealthiest debtors. IMF loans are like US Federal Student Loans: they never go away, however long you’re in default. International aid organizations stick up for each other, so Greece would be a pariah in that community until it made a deal to get out of default.

The third big group of Greek creditors are Greek institutions, mainly banks and pension funds. Of these the biggest chunk is the €13.3b of short-term treasury bills that were outstanding as of the end of September. Greece wouldn’t gain anything by defaulting on these debts, except big losses for its banks. The EU and IMF appear to be assuming that these debts will be rolled over.

And finally there are the holdouts who refused to participate in the 2012 restructuring. So far they have been getting paid 100%, which must be galling for everybody who took haircuts of 53.5% by face value and about two-thirds by net present value. But the holders of these bonds are largely vulture investors, who know how to cause enough pain in foreign courts to make it not worth the fight. And they bought the best bonds to go to court with. I haven’t got the details on how much of these come due in 2015-2016, but I’m guessing it’s less than €2b since there were only €6.4b of holdouts in total and some have already been paid.

Rebel All You Want, You’re Still Trapped

 Anyway you slice it, there’s very little to be gained by defaulting. Defaulting on debts to domestic banks would be suicidal. Defaulting on debts to European central banks would kick off an unpredictable legal battle with EU institutions, which hardly seems worth it given that the debt is interest-free till maturity and the EU can probably be convinced to roll it over into multi-decade, near-zero-interest loans. Defaulting on the IMF would make a pariah of Greece and seems pointless when the IMF is offering to roll over most of the debts that come due to it over the next two years.

And consider one more thing. Although none of Greece’s EU bailout loans come due anytime soon, if Greece defaults on Eurosystem or IMF loans it would be effectively stiffing the EU. The EU could respond by suspending structural aid, which is worth more than Greece could save in interest costs by defaulting. Greece received €4.65b of EU funds in 2014, while paying €2b as its contribution to the EU budget. That’s a net inflow of 1.5% of Greek GDP, bigger than Greece’s primary surplus.

The harsh truth is, Greece is boxed in. Trapped as trapped can be. So Greeks elected the only people who claimed to know a way out, however radical. But what can the Tsipras government actually do? I suppose it could make a show of throwing itself against the walls that surround it on every side. That might be what Greek voters are expecting.

Everyone hates austerity. Greece doesn’t have enough money to reverse its austerity. Who’s going to give it? You?