The Economist calls attention to a new IMF staff report that lays out the challenges ahead for Greece. According to the report, the Greek government’s primary budget deficit in 2009 was 8.6% of GDP. That represents the amount by which spending would have to be cut or taxes raised in order to balance the budget last year even if Greece were to repudiate all its outstanding debt. Interest expense on the outstanding debt added another 5.0% of GDP to the 2009 government budget deficit. The IMF calculates that even if austerity measures amount to 10.9% of GDP by 2013 (turning the primary deficit into a primary surplus), the interest burden on Greek’s debt would still grow to 8.1% of GDP by 2013.
One logical response to these circumstances would have been for Greece to abandon the euro, and at a minimum pursue major debt restructuring such as converting outstanding debt to drachma at some rate. That of course would have invited speculation as to which other European countries would be next, which would show up among other places as a surge in borrowing costs for those targeted countries. There is certainly a benefit to countries of being part of a common currency area, but there are also significant costs. The imperfect synchronization of the business cycle across European countries means that the monetary policy appropriate for some may be causing disruption in others, and the desired long-term inflation rate may also differ across countries. Breaking up the European monetary union would undoubtedly be disruptive. But is it worth a trillion dollars to avoid?
I suspect that the key fear has to do with the consequences of a default or restructuring of the debt itself. Willem Buiter estimates that French and German banks have € 110 billion exposure to Greek debt, and total exposure to a potential domino effect could be huge. The WSJ today has further breakdowns, and Dow Jones reports that JP Morgan’s holdings of non-U.S. government bonds increased by $36.5 billion in 2009, while Citigroup’s increased by almost $40 B.
We could then be talking about a replay of the same kind of bank run as we saw in 2008. As creditors who’d lent short-term to banks worried about the banks’ exposure to these risks, banks would be forced to liquidate holdings at fire-sale prices which could again bring lending of all sorts crashing down.
And, as was the case in the 2008 difficulties, one can either view this primarily as a liquidity problem, for which we simply need the central banks to step in boldly to arrest the jitters, or as a solvency problem, in which case the policy decision is how to allocate the unavoidable capital losses among bank owners, bank creditors, and the government so as to minimize collateral damage to innocent bystanders. The fundamentals facing Greece suggest there is an overwhelming solvency component to the current problems. And the policy response so far seems to be choosing to allocate 100% of losses to the European and U.S. taxpayers.
It is not the role of the ECB, IMF, or Federal Reserve to bail out banks. These measures are profoundly unpopular with voters in countries such as Germany and the United States. I think it is incumbent on the architects of these measures to communicate what is the structural defect in banking regulation that made such intervention necessary, and what reforms have been implemented to ensure that such measures won’t be needed again.