Crisis watch: Why Greece should default

Kazakhstan may be far removed from the eurozone, but its recent economic experiences are highly relevant to the latter’s current travails. As the weaker members of the eurozone struggle with debt crises and austerity, Kazakhstan is emerging from a massive banking-system collapse with a strong economic recovery. For most of the last decade, Kazakhstan gorged on profligate lending, courtesy of global banks—just like much of southern Europe. The foreign borrowing of Kazakh banks amounted to around 50 per cent of GDP, with most of the money used for construction. As the cash rolled in, wages rose, property prices reached near-Parisian levels, and people fooled themselves into thinking that Kazakhstan was Asia’s latest tiger. The party came to a crashing halt in 2009, when two sharp-elbowed global investment banks accelerated loan repayments hoping to get their money back. The Kazakh government, which had been scrambling to support its overextended private banks with capital injections and nationalisations, gave up and decided to pull the plug. The banks defaulted on their loans, and creditors took large “haircuts” (big cuts in the value of their loans). But—and here’s the point—with its debts written off, the banking system is now recapitalised and able to support economic growth. Despite a messy default, this fresh start has generated a remarkable turnaround. The western European way of dealing with crazed banks is different. The Irish banking system’s external borrowing reached roughly 100 per cent of GDP. When the world economy dived in 2008-09, Ireland’s party was also over. But here’s where the stories diverge, at least so far. Instead of making the creditors of private banks take haircuts, the Irish government chose to transfer the entire debt burden onto taxpayers. The government is running budget deficits of 10 per cent of GDP, despite having cut public-sector wages, and now plans further cuts to service failed banks’ debt. Greece is now at a crossroads similar to that of Kazakhstan and Ireland: the government borrowed heavily for the last decade and squandered the money on a bloated (and unionised) public sector (rather than modern—and vacant—property), with government debt approaching 150 per cent of GDP. The arithmetic is horrible. If Greece is to start paying just the interest on its debt—rather than rolling it into new loans—by 2011 the government would need to run a primary budget surplus (excluding interest payments) of nearly 10 per cent of GDP. This would require roughly another 14 per cent of GDP in spending cuts and revenue measures, ranking it among the largest fiscal adjustments ever attempted. Worse still, these large interest payments will mostly be going to Germany and France, further removing income from the Greek economy. If Greece is ever to repay some of this debt, it will need a drastic austerity programme lasting decades. This would cause its GDP to fall far more than Ireland’s. Moreover, Greek public workers should expect huge pay cuts, which, in the country’s toxic political climate is a sure route to civil strife. European leaders are wrong to think that Greece can achieve a solution through a resumption of normal market lending. It cannot afford to repay its debt at rates that reflect the inherent risk. The only means to refinance its debt at an affordable level would be to grant long-term, subsidised loans that cover a large part of the liabilities due in the next three to five years. The alternative for Greece is to manage its default in an orderly manner. Reckless lending to the Greek state was based on European creditors’ terrible decision-making. Default teaches creditors—and their governments—a lesson, just as it does the debtors: mistakes cost money, and your mistakes are your own. With each passing day, it becomes more apparent that a restructuring of Greek debt is unavoidable. Some form of default will surely be forced upon Greece, and this may be the most preferable alternative. A default would be painful—but so would any other solution. And default with an “orderly” restructuring would instantly set Greece’s finances on a sustainable path. After tough negotiations, the government and its creditors could eventually slash Greece’s debt in half. Greek banks would need to be recapitalised, but then they could make new loans again. A default would also appropriately place part of the costs of Greece’s borrowing spree on creditors. The Germans and French would need to inject new capital into their banks, and the world would become more wary about lending to profligate sovereigns. Ultimately, by teaching creditors a necessary lesson, a default within the eurozone might actually turn out to be a key step toward creating a healthier European—and global—financial system.