Five ways to correct the Greek debt crisis

By Mohamed El-Erian
May 3, 2011

By Mohamed El-Erian
This piece is the English version of the one that appeared in Handelsblatt. The opinions expressed are his own.

Not a day goes by without a flood of comments on Greece and its debt problems. They seem to come from everywhere. Some are later denied while others are left to stand, accompanied by a continuous string of worrisome data. In the process, even greater disorder is gaining hold of the country’s debt markets, with credit spreads exploding in an ever more alarming fashion.

There is a risk that all this could serve to confuse rather than illuminate the key issues that should be on the radar screen of many, whether they are policymakers or normal citizens. I can think of five such issues.

First, there is a good reason why Europe’s current approach to Greece’s problems has not worked well. Indeed, many, including me, believe it will not work any better going forward. Meanwhile, the costs and risks are growing exponentially.

Despite a year of large sacrifices on the part of Greek society and exceptional financial support from neighbors, Greece is still very far from regaining economic and financial stability. Output continues to collapse, unemployment is rising, the budget deficit remains alarming, and the already excessive debt burden is increasing further.

As a result, the country is no closer to re-establishing normal access to the global financial markets. New investors prefer to wait on the sideline, thereby starving the country of fresh capital. Meanwhile, doubtful liabilities are increasingly being transferred from creditors, who knew they were taking risks in lending to Greece (rather, for example, than buy German debt at a lower interest rates), to Greek and European tax payers as well as to the balance sheets of public organizations.

Second, the time has come to urgently recalibrate the EU/ECB/IMF approach to solving Greek’s debt crisis. This must start with an open recognition that an insufficient number of the original key objectives of the Greek adjustment program have been realized and, going forward, even fewer stand any realistic chance of being realized under the current approach. As a result, the country will not be able to harvest gains from the courageous steps taken to improve the efficiency and functioning of the public sector. Indeed, it could be forced to reverse them.

This is not to say that the approach has been a complete failure. It has not, especially given that it reduced regional contamination risk by giving time to other vulnerable entities in Europe to enhance their economic and financial defenses. This has been particularly important for Spain and for those banks that have taken advantage of the last year to raise capital.

Third, none of this should really constitute a total surprise. Indeed, a lot, though not all, is very familiar to those that lived through or studied the Latin American crisis of the 1980s. It is also consistent with lots of academic work on debt traps and solvency problems.

The basic issue is a simple one. You don’t solve a debt problem using mainly a liquidity approach.

Piling new debt on top old of debt is not a durable solution. At best, it buys time. But this comes at a cost. For example, Latin America suffered a “lost decade” of growth, employment and investment in the 1980s. Greece is undergoing the same risk today. But there is also a critical difference that makes today’s approach to Greek’s debt crisis even more problematic over the long term.

In Latin America, the international community was able to force banks to continue to lend. This limited the transfer of doubtful liabilities to the public sector. And, when the time came for a debt restructuring, the banks suffered a haircut of over 50 percent

In the case of Greece today, too much of the debt is being transferred from creditors to the public sector. As a result, too many tax payers and public institutions will end up taking the hit that many creditors should have taken.

Fourth, the urgent recasting of Europe’s current approach to the Greek debt crisis must focus more explicitly on the objectives of addressing the country’s solvency problems, restoring medium term growth and employment creation, and stopping the erosion in the integrity of European and multinational institutions.

In Greece, austerity must be mixed with more meaningful structural reforms that restore the country’s competitiveness and growth potential. The approach to the country’s debt must mix liquidity with solvency solutions, preferably (and if still possible) through a voluntary and orderly debt restructuring. European and multilateral financial support should be better targeted, structured, and disbursed; and it should reside on fiscal balance sheets rather than those of monetary institutions. And reasonable and sustainable fire lines must be established to limit regional contagion.

This leads to the fifth and final issue. If urgent action is taken, Greece need not end up risking the very concept of the Euro zone.

It is unfortunate that the Greek debt saga has diverted attention from many positives that are in play today in the Euro-zone. I am thinking here of Germany’s underlying economic strengths and achievements, earned through years of brave structural reforms. I am also thinking of the considerable efforts made by Spain to avoid being placed in the difficult dilemma that Ireland was put in—efforts that are critical to Spain limiting the risk of it joining the ranks of the three struggling peripheral economies (Greece, Ireland and Portugal).

The time has come for Europe to recognize the need for a meaningful mid-course correction to its approach to the Greek debt crisis. The current approach has not worked well enough, and will do even worse going forward.

The longer European leaders ignore the fundamental issues, the greater the risk to Europe’s institutions, to its credibility, and to its shared strengths and responsibilities. And, the greater the risks to the global economy.

5 comments

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The most important fact is that Greece fudged it’s data to join the Euro and has not and will not be able to meet the criteria of membership. Greece is not alone in this respect. There needs to be a recognition that the ‘one size fits all’ economic policies of the Eurozone are a mistake. To continue to impose them on the ‘southern’ countries is to condemn them to years of austerity. They need to devalue.

Posted by pavlaki | Report as abusive

We all seem to be real good at asking for more money/what our country can do for us, and very poor when it comes time to cut spending/compensation!
Seems a flat/fair type tax might work best in Greece-too many under the table! Same with the US!

Posted by DrJJJJ | Report as abusive

Good solution, but it promotes that the bill will end with the wrong taxpayers. This cannot be the case. The Greek have gone to far, the government has corrupted the data. Ever heard of moral hazard ? Well, here it is written all over the story of Greece.
Here is another solution that is more ethical:
- The Greek increase their pension age to 69, like in all ‘rich’ European countries.
- The Greek will start paying taxes, like in all ‘rich’ European countries.
- The Greek will repay 100 % of their debt, like in all ‘rich’ European countries.
- The Greek public servant will lose their privileged jobs, like in all ‘rich’ European countries.
Only then will the wound of distrust that has been created will be cured. Honesty takes longer.

Posted by FBreughel1 | Report as abusive

You see Mr. El-Erian, from the responses on the article, there is a new thinking which is a little more ethical and tougher then before. That is because hard-working people have been tolerant, have been generous, have been paying their taxes and have been providing all this. But the fun is over and Keynes is dead. Who-ever wants to survive in politics better understands this. For instance in Germany, Mr. Schäuble was not doing his party a favour by telling Greece was going to restructure. CDU already knows the outcome of the elections next year, which will be bad, very bad. Therefore, you will not find much support for your plan, maybe in a niche with old left-wing parties, or with the former communist new EU entrants. Greece is going to pay, and if they go default, or have to leave the EU, do you think we mind ? No. It is new economics, and it better then the way it was, simply because it supports not just the weakest but also the honest. Greece still has a chance, and they have the next ten years they are worthy of being part of such an exclusive club as Europe. We have bought them the time to prove it.

Posted by FBreughel1 | Report as abusive

Quote from the article: “In the case of Greece today, too much of the debt is being transferred from creditors to the public sector. As a result, too many tax payers and public institutions will end up taking the hit that many creditors should have taken.”

This is the primary problem of economies around the world as evidenced by Iceland, Ireland, Portugal, Spain and even America, but Greece’s problem is far greater.

Greece’s underlying fundamentals are so wretched that they have zero chance of achieving economic viability within the next ten years.

This epic drama can only end with loan forgiveness or default… and the end draws ever closer.

I’m astonished that the Eurozone and other investors have been willing to toss billions of Euros into Greece’s black hole of a deficit every time the bills come due.

Surely, most of those investors are sophisticated enough to know that Greece isn’t capable of generating enough income to actually repay all of that money. The risk of default is virtually 100%; it’s just a matter of when.

Posted by breezinthru | Report as abusive