Saturday, 24 November 2012

Stop the Cuts and Fund the Reforms

Greece’s economy and society are imploding. GDP has declined by almost 25% since the start of the crisis. Unemployment has tripled and stands at 25%, with youth unemployment twice that. Crime is on the rise and so are racist incidents. Ideologies of the extreme right and left are gaining significant support.
Current policies are not stemming the economic decline. The new three-party government elected in June has focused its energies on negotiating a new package of austerity measures to meet the Troika’s (ECB, Eurozone, IMF) conditions for the disbursement of the next tranche of the bailout loan. Genuine reform, such as building a well-functioning public administration and liberalizing markets, is lagging behind, but is Greece’s only pathway to growth. Reform is resisted by Greek politicians and vested interests, but is also greatly under-emphasized by the Troika relative to austerity.
On its current course, Greece is headed for disaster: further declines in GDP, a possible chaotic default on its debt, extremist political parties in power, and isolation from Europe. Europe will also lose since the decades-long process of integration will be reversed and the credibility of the Euro will be undermined.
Assuming that Greece’s European partners want to avoid such an outcome, which could occur soon, they should devise a clear long-term strategy with two objectives: reduce drastically Greece’s debt, and ensure that Greece’s dysfunctional economy is thoroughly reformed. The two objectives are mutually reinforcing, unlike what is commonly believed.
Greece’s debt is projected to rise to 189% of GDP next year, up from 129% in 2009. This is despite the restructuring of privately held debt and drastic austerity measures that have almost wiped out the government’s primary deficit. Most of the increase in the debt-to-GDP ratio is due to the large decline in GDP. Further austerity, aimed at generating the large primary surplus necessary to start reducing the debt, will cause GDP to fall further, making the debt-to-GDP ratio even larger. It is therefore impossible for Greece to ever repay its debt in full. Its European partners should recognize this and write off a significant fraction of the debt, so that Greece can grow and repay the rest.
Writing off Greece’s debt can be done in a way that preserves, and indeed promotes, incentives for reform. A fraction of the officially held debt, e.g., 50% or more, should be set aside to be written off gradually over the next five years or so conditional on Greece achieving a set of milestones concerning institutional and market reforms, e.g., render the public administration more efficient, speed up judicial proceedings, reduce corruption, liberalize markets, etc. Achievement of these milestones could be monitored using existing indices constructed by institutions such as the World Bank and the IMF. Such a scheme will promote reforms, and so put Greece’s debt, which cannot be repaid in full anyway, to good use.
More generally, the Troika should emphasize reforms rather than the rapid achievement of a primary surplus. The initial emphasis on reducing the deficit was appropriate given the deficit’s unsustainably high level. However, continued austerity is counterproductive because it undermines reform. For example, recent deep salary cuts in the public administration are triggering the departure of talented personnel, thus impairing an already weak organization and exacerbating further the core problem of low public-sector productivity. Public agencies in charge of key tasks such as tackling tax evasion, supervising financial markets, and prosecuting white-collar crimes, are often short of funds, equipment, and the ability to attract talent. The Troika should ensure that such funding needs are met, regardless of any effect on the deficit.
Reforms have been resisted so far by Greek politicians and vested interests (with some of the same politicians voting instead for the austerity measures). Yet, it is hard to imagine how Greek politicians would oppose the reforms if these were the condition for writing off a large part of the debt and averting disaster. An emphasis of reforms and debt reduction would be welcome by the Greek population, whose support is necessary for the reforms to succeed. By promising debt relief in exchange for reforms Greek voters will stop listening to the demagogic rhetoric of the extremist parties.
It is time that we all admit that the only way forward for Greece is to reinvent its economy. Resisting structural reforms is suicidal. On the other hand the insistence by the troika on further cuts is catastrophic, as it will lead to a continuing downward spiral of the economy and to a severance of the links of Greece with its natural ally – Europe. And of course the creditors are not going to see one penny back.

Costas Meghir, Dimitri Vayanos, Nikos Vettas

[1] Meghir is Professor of Economics at Yale University, Vayanos is Professor of Finance at the London School of Economics, and Vettas is Professor of Economics at the Athens University of Economics and Business.

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