The Financial Times provided this analysis of the latest Greece deal a couple of days ago. I've delayed writing about it because, to be perfectly honest, the details stretch my competency in this area. I'm not entirely sure I'm getting the intricacies. But I figure I'll take a crack anyway. To understand this solution, I think the first step is to identify the issue.
Briefly, Greece is basically insolvent. Going into the financial crisis, they had large debts, a hugely wasteful public sector, didn't collect taxes, and papered over it with creative accounting and through the fact that bond markets either weren't distinguishing between more and less creditworthy Euro zone nations, or were assuming that the EU would bail out its weaker members in the event of a crisis. Or maybe it was both.
Either way, when the economy melted down, borrowing dried up, and you had a country with a lot of debt, a massive primary account deficit, and a bloated public sector full of workers who didn't have too many real skills. In normal circumstances, this would be a good time for a central bank to lower interest rates to 0 to get workers working while the government got its fiscal house in order. If the problem was really severe, you could default on the debt, forcing bondholders to take a haircut, devalue the currency to make exports competitive, and export your economy back to growth. Citizens' standard of living would be cut (exports would get way more expensive), but at least people would be working.
But Greece's situation is complicated by the fact that has neither its own currency nor, as a result, its own monetary policy. That means lowering interest rates unilaterally is impossible, as interest rate cuts for Greece would likely spur significant inflation in Germany (a much stronger, and also much bigger, economy). Additionally, Greece has essentially been frozen out of credit markets (for obvious reasons, investors aren't excited to buy Greek bonds at anything but sky-high coupons that Greece can't really afford to pay anyway). So Greece has no monetary policy levers for softening its landing and allowing it to grow its way out of the crisis, nor can it borrow its way back to full employment through productive public works projects.
So Greece is stuck between a rock and a hard place. It has a massive debt that it has to service, and a fat deficit that it has to mitigate. At the same time, given the severe imbalances in its economy at the time of the crisis, raising taxes and cutting spending actually reduces demand, which in turn lowers tax receipts further. And the burden of the debt isn't going anywhere. And borrowing any more at today's rates just digs Greece into a deeper hole. It's collapsing, and there's no way out without extraordinary measures.
That's the context in which the latest European rescue plan should be looked at. I won't get into the details of the four options for investors, in part because I'm not confident I can really explain how each would really help in a way that makes all that much sense to me, much less to someone else. But the general proposition is that there are two essentially different approaches, each of which can be structured in two different ways. The first maintains the principal of the bonds, but lowers the coupon (interest rate), while extending the maturity. This provides Greece liquidity relief in the short term. In other words, Greece will owe less money up front, but will owe more on the back end, the idea being that if Greece can get its economy into a self-sustaining growth trajectory (with the help of the liquidity relief), it will be able to pay off the bonds in full on the back end. The bonds are collateralized with AAA-rated bonds bought by the European Stability Fund that the EU put together. If I understand it right, Greece is essentially borrowing the stronger EU countries' creditworthiness so that it doesn't have to borrow in credit markets at its own unaffordable rate.
The second set of options involves a write-down of the principal. Simply put, the bonds are written down (by 20% in each case), but the coupon is raised. In the second option under this category, further losses to the principal are collateralized by funds provided by an EU rescue fund. The idea behind these options is that the write-down in principal provides solvency relief on the balance sheet-- without having to pay back the full cost of the bond, the Greeks get some relief.
Frankly, the biggest difficulty for me is understanding how these options interact (and I don't even fully understand the last option, even after reading over it a bunch and trying to think it through), and understanding how they might expect to get relief under these scenarios. All of the liquidity relief is only useful if Greece can stimulate growth that lets it collect enough in taxes to pay off its debts, even with the lowered coupons/principal. I think a useful metaphor is that Greece is floating out at sea, trying to get to land. The rescue plan is a life vest, but the vest only keeps them above water-- it doesn't get them any closer to the destination. And, ultimately, I think that's the problem. Greece can't solve its debt problem without economic growth. And the debt problem is a drag on growth. And, without its own monetary policy, and with its fiscal policy crippled by its debt overhang, Greece really has no way to stimulate growth.
And a problem both FT and Paul Krugman pointed out is that the debt relief measures are all voluntary for bondholders. In other words, they don't HAVE to take any of them. Which makes me think they're not going to amount to anything. The incentive is for every bondholder to let the others participate, but hold off on participating themselves. That way, they don't have to lower the principal or the coupon, and get paid in full on the back of everyone else taking haircuts. But that incentive applies to every bondholder, so I think the most likely result is just that no one chooses to participate, in which case the ideas are a moot point. Or, alternately, a few participate in good will, but their participation doesn't make a difference as not enough bondholders take part. In which case, Greece not only doesn't get its debt relief, but participants also get burned compared to those who held out.
In short, my impression is that this plan, to the extent that I understand it, probably isn't going to do much good.
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