What should Greece do?

There’s been a lot of discussion of the problems of Greek sovereign debt, its implications for the euro and so on. But I haven’t seen much discussion of what the Greek government should do in dealing with the simultaneous problems of an economic downturn and unsustainable debt (feel free to point me to good discussions).

The course of action being demanded by the bondholders and their advocates, as well as by the EU governments that are likely to bear the costs of a bailout is that of drastic retrenchment on the lines the IMF would normally advocate in cases of this kind. But that is obviously not a desirable policy response when considered in macroeconomic terms. I’m not well informed on the details of Greece’s budget problems, so I’m mostly going to make generic suggestions that are applicable to a case like this.

What Greece needs, if it can be delivered is a policy that will maintain its access to credit markets, while avoiding a drastic contraction in the short run. That requires a credible commitment that holders of Greek government bonds will be paid in full, or fairly close to it, a commitment that is inconsistent with sustained budget deficits.

The strategy that seems to be indicated is one that has the following main characteristics

* A sustained increase in the ratio of tax revenue to national income over time. That suggests a commitment to raise the VAT rate gradually over several years, with the extra revenue being hypothecated to debt service. On the income tax side, the most credible commitment to raise revenue in the long run is probably one of vigorous action against tax avoidance and evasion, benefitting from the efforts of the bigger European economies in this respect

* On the expenditure side, it’s likely that Greece, like most countries has unsustainable commitments on retirement incomes. A staged increase in retirement and pension ages, as has been done in Australia, is a reasonably credible way of constraining future growth in expenditure without too much adverse impact in the short run.

* Finally, there are the various non-conventional ways previous governments found to take on debt obligations, for example by mortgaging future income flows. Unlike the case of standard government bonds, there is no need to preserve access to this kind of borrowing in the future. On the contrary, action to ensure that no future government can borrow in this surreptitious fashion is highly desirable. So, these deals should be renegotiated to reduce the burden they impose, with the threat of repudiation/default in the absence of a satisfactory agreement. The prominent role of major Wall Street banks in organising these deals is a potential political asset here. An outcome in which Goldman Sachs gets stiffed, while bondholders in general are paid, would be an ideal way of softening the political pain associated with expenditure cuts and tax increases.

95 thoughts on “What should Greece do?

  1. Andrew R.

    I’d prefer to drop the topic of systemic risk because your last post indicates to me that you see everything from the perspective of ‘an accounting entity’.

    It was Goldman-Sachs that sold the Greek government the derivatives which constitute a problem at the time of entry to the EU in 2002. Their involvement resulted in economically misleading national accounts about which the EU Commission isn’t happy at all. And it is Goldman-Sachs which approached the Greek government late last year. They have learned nothing. (I wonder how much more has to happen before the operating license of GS for the EU will be withdrawn.)

    I appreciate that rating agencies offer a convenience for people at trading desks by providing parameter values to be put into a computing program to ‘price’ securities. But I can’t see why payment for such non-recourse services should be a tax deductable expense, given the consequences for taxpayers in many country for their ratings of hot potato securities (risky debt portfolios at the time of issue) as investment grade. There is no excuse I can think of because the relevant theoretical literature had been available for a long time in the public arena – ie ‘full disclosure’ was in place. But my opinion doesn’t count for the problem at hand. What matters is what the EU Commission and the Greek goverment and the EU people in general think of rating agencies.

    The EU Commission doesn’t seem to be in the mood to take rating agencies seriously. As mentioned, Greece may have to put up with financial supervision from the EU Commission.

  2. “Governments and individuals are separate entities and lenders understand the distinction.”

    I’m not saying you are not making a fair point Terje. But why impute any human understanding to these morons/welfare queens? If they are not simpletons, then surely they must be cynical jackals, entirely confident of their ability to steal, when their incompetent lending practices come unstuck. I don’t think you are fully coming to grips with the mis-allocation of resources here. Capitalism is supposed to be a system of effective capital markets. A system that allocates resources to the areas of greatest wealth creation. Is that what we are seeing when these bozos are financing the Greek government deficit? When they are financing land inflation as opposed to small business expansion?

    Clearly something is terribly wrong here. And yet you and Andrew seem to want to carry on with the delusion that this is a functioning free enterprise industry.

    These people have failed. They are not smart. Some of them are incredibly rich. But there is a difference between being smart and being rich. At least in this industry there is. A fool and his money may soon be parted. The exception being if you are a rich banker. Because thats a heads-I-win, tails-you-lose situation. Rent-seeking requires only political instincts. It does not require the high intelligence of wealth creation. Hank Paulson is not Steve Jobs. In fact Hank is a real dummy.

    These issues are important. Its hard to think of any other industry, the reform of which, could lead to greater improvement in our living standards. Medicine perhaps. But in any case there is a lot of work to do. A lot of reform to be had. Any idea that these bankers are doing a good or acceptable job will get in the way of that.

  3. “Ernestine,
    I would have thought a more credible option would be to default on the debt and off balance sheet financing that was not made public (if indeed you are right). That would penalise the financiers that provided the funds that were provided in a less than transparent manner and show that the new government was determined to clear things up.”

    Why not default on all of it Andrew? If lent in plain sight or off the books, its all bad lending. Is it really the case that these people will get punished for any of their wrongdoing or incompetence? We haven’t seen that lately have we? Here we have these people who ought to have been cleansed and bankrupted. But two years later they are still getting in our face. Giving our governments horrendously bad advice. For example is that rail sell-off still going ahead in Queensland?

  4. Andrew Reynolds :EG,Looks like we crossed comments, there.A forward contract, whatever you want to call it is a derivative, as are swaps (another form of forward contract) and so are many other things – such as the “getting the loans off your books” style contracts you are talking about. They are all forward contracts.If you are going to continue this discussion, then please let me know what you are talking about, as you seem unclear.If you do not regard forwards as derivatives, then CDOs are not derivatives. Que?

    This is off topic. Perhaps you confuse futures contracts with future contracts. I suggest you write down the contractual relationship of a future contract, using the language of mathematics, and you’ll see that a future contract has the same structure as a plain vanilla debt contract. Moreover, all the important information fits into a financial accounting framework. Do the same for an option and you’ll see the difference.

  5. Ernestine,
    You may prefer to, but I disagree. I do not see it solely or even mainly from the standpoint of an accounting entity, despite the fact I have considerable accounting knowledge on the Standards relevant to a banking or insurance entity – enough to know that your micro analysis is faulty as well.
    For a start, you have not reconsidered your manifest misunderstanding of what a derivative actually is. Please clarify on this. If you do not see forward contracts as derivatives, then the CDS instruments that our host here (in another post) is talking about as a problem are not derivatives. If they are not, what are they?
    If you want to stick with micro issues, then perhaps we can look at another area where my applied knowledge may be useful to help evident misunderstanding. Let’s look here:

    The ‘legitimate’ (regulatory) reason are known as capital adequacy ratios (accounting type ratios). By getting loans ‘off their balance sheets’ the said banks are using the same amount of equity more than once to generate accounting profits (and bonuses) by means of lending more.

    (Emphasis mine)
    This, if I may say, is nonsence. The only way you can get these things off your balance sheet (legitimately at least) is by actually selling them – i.e. through the introduction of a new entity (with its own equity) to which you are selling the assets. The precise wording in the relevant accounting standard is to “…transfer substantially all the risks and rewards of ownership…” (IAS 39 para 20(a), with similar wording in the US FAS 133). Regulators have a slightly lower standard (not greatly lower), but all of them involve the introduction a new entity (with its own equity and assets) into the structure to which you are selling them and all of them require the introduction of valuable assets into the selling entity. If the asset introduced is not cash or an equivalent then there is no capital relief as the new debt to you attracts a capital requirement – in fact there may be additional capital required.
    Sorry, EG, but on either macro or micro I cannot see how your argument stacks up.

  6. EG,
    Again, your last comment crossed mine – but I feel the confusion is yours. A futures contract is a special type of forward contract, one traded in a standardised way on a futures exchange. A futures contract is just as much of a forward contract as any other.
    Let’s just look at some definitions, EG. It may help.
    In a forward contract the two (or occasionally more) counterparties agree to exchange certain items of value in the future. Neither has the option to back out of the deal under normal circumstances. Into this category falls such instruments as vanilla forward contracts, interest rate swaps, credit default swaps, collateralised debt obligations and such. These derive their value from some underlying – in the case of a currency forward it is the difference between two spot currency rates and the relevant bond rates and in the case of a CDO it is the expected future cashflows from the subject debt obligations.
    The option contract gives the holder the right, but not the obligation, to enforce delivery in the future of a fixed or determinable amount of some underlying. Into this cateory falls such instruments as vanilla options, swaptions and many more exotic derivatives. Personally, I have always liked the binary payout ones, but that is not relevant here. Inthe case of an option it derives its value from the underlying, the optionality and the time to run.
    .
    The ones that our host here and, IIRC, you have been most vocal about are forward contracts – the CDS and CDO style derivatives that are just as much a forward contract as a plain vanilla boring old currency forward. Are these not derivatives, then? If so, your argument is nonsensical.

  7. Andrew R.
    You are taking this way off topic. But given your statements I see a need to reply.

    I said @23 that I would not classify a forward contract as a derivative. At 28 I talked about a ‘future’ vs ‘futures’ contracts. The term ‘future’ contract is a theoretical concept while ‘futures’ are securities currently issued and traded. The empirically existing forward contracts have properties akin to a future contact. A forward contract specifies the amount of cash paid by the buyer of the contract at time t to the seller of the contract in exchange for a contractually fixed amount of something, say 1 unit of y, to be delivered by the seller of the contract at time t+k at a predetermined price. The amount of cash paid at time t is the price of the forward contract. (The theoretical concept of a future market contract specifies the price at time t for delivery of 1 unit of y at time t+k. Surely this makes it clear that a forward contract is akin to the theoretical concept of a future contract). A forward contract is clearly a risk management contract for which it is not difficult to see why both sides of the market have a purpose. Similarly, a plain vanilla debt contract specifies the amount of cash (currency) the buyer of the contract pays at time t in exchange for an amount of cash (currency) to be delivered by the seller (issuer) of the contract at time t+k. (The difference in the two amounts can be expressed as an interest rate.) The structure is the same. Now, write down in this plain language (in the comfort of your privacy) what the contract of an option is and you’ll see the difference. Financial contracts are governed by one simple question: Who gets which amount when and under which conditions? Remove the many words and the wool can’t be pulled over people’s eyes. CDOs, rated by your beloved rating agencies as investment grades involve a lot of wool over people’s eyes. The actual contract is akin to saying I sell you something which I don’t know how to write down in your balance sheet but, believe me, it is as good as a debenture issued by BHP.

  8. The literal answer to the question of what Greece should do, is to cut spending. Not slice of all old age pensions. Or trash every last dollar of defense spending. Not fail to repair roads. Or fail to have some persistent but patient, ongoing program of infrastructure spending. Not auction all the public goods, without a good plan for a subsequent non-cronyist industry.

    But rather Greece should line up all those departments that they may like and find helpful, but that they can do without, and just get rid of them. In other words Greece ought to do what we ought to be doing. They ought to be far more ruthless with spending. Not ruthless or cruel with aged welfare recipients. But with all that spending that you can get rid of and nobody is likely to die as a result.

    Once they are on a clear path to surpluses they can and must repudiate their bank and government debts. They will be doing everyone a favour if it brings down dysfunctional lending institutions when they do so.

  9. Ok – let’s look at a typical option contract. This is one that one of my clients took out.
    They are gold miners in WA. They calculated their likely gold production a number of years forward and looked at their likely costs to mine and process that gold. The total cost was, say $x at time t, $y at time t+1 and so on. The gold price at the time was $x + $400 or so.
    They decided to hedge their risks but did not want to unduly limit the potential upside, as they were (and, incidentally remain) very bullish on the future price of gold.
    They decided to take out put options on gold at a strike of $x + $100 for time t+1 and at $y+$100 for time T+1 and so on out to the limit of projections.
    As these contracts were deep out of the money they were very cheap.
    So, for those very cheap options, they effectively ensured (short, obviously of the collapse of the bank counterparty) that they will have a profitable business for years to come.
    I suggested that, to reduce the possible impact of the collapse of the bank that they could take out another forward contract (a CDS on the bank) to cover on the risk of the default of the bank, but that as this risk was minimal it was possibly not worth it.
    Was that a good illustration of how to use an option contract, Ernestine?
    .
    The ratings agencies are not “beloved” of me in the same way that academic texts seem to be for you. They are, as I have said many times, run by humans and subject to error (for whatever reason) just like anyone else.
    The CDOs were a waterfall instrument (and a forward contract – sorry to point that out again, but you still seem to think them as some kind of option) and everyone who looked at them seriously knew that (if you are unsure what a waterfall instrument is, please just ask and I would be happy to help, as usual). The fact that the ratings agencies evidently got the ratings wrong (and may have been collusive in the error with the issuers) does not change the fact that they were not options.
    There was no “wool” under these contracts, Ernestine – but there is plenty of woolly thinking about them.

  10. @Andrew Reynolds
    Andrew..you said to Ernestine…
    “The ratings agencies are not “beloved” of me in the same way that academic texts seem to be for you.”

    Id call this comment for what it is…an attempt to compare the conduct of ratings agencies with those compiling academic texts.

    There is no comparison. They march to the beat of a different drum. One nobler than the other.

  11. Alice,
    Interesting to see your implied praise of nobility, but nobler or not, given the arguments advanced here and the economics textbooks I remember from many years ago I know which is more error-prone.

  12. Andrew R. You are again taking this thread way off topic. But given what you wrote, I see a need to reply.

    Where or when did I say that a CDO is an option? I did not. I did say that a CDO is a derivative (but a forward contract is not) and I did say that a European call (or put) is the simplest example of a derivative.

    You are giving me a standard commerce textbook illustration of how to use a put option from the perspective of one accounting entity without giving me the conditions under which this is consistent with financial system stability. Your example looks like an over-the-counter option deal.

    As for financial stability, you are bringing water to JQ’s mill regarding the desirability of narrow banking when you reveal so nicely that banks are acting as speculators when they provide insurance for business risk (and in doing so they provide conditions to substitute debt for equity because the future net cash flow stream is nicely bounded and the corporation can buy back equity with money borrowed from, yes, a bank, just after share options have been issued to management – not manipulable at all, eh? Sorry, your words are ‘integrated’. There is more to economics than introductory micro, macro and accounting.)

    May I ask you to now stop this conversation because it is totally off topic.

  13. So – you want me to end it with the errors in the last comment uncorrected and giving the appearance that you were correct? You have little chance of that.
    For a start, you have not corrected yourself on (or attempted to give a workable definition of) what in fact a derivative is. A forward contract (even a plain vanilla forward) is, without question, a derivative in every single textbook or practical application of the word. If you seek to redefine derivative, please at least have the courtesy of providing (and perhaps justifying) that definition.
    Also as a point of fact CDOs does not meet some of the classic definitions that would classify it as a derivative – as what they represent is an entitlement to future cashflows, rather than being an instrument that derives its value from that of another instrument. Let’s be charitable, though, and agree that it is (keeping in mind, though, that there is that doubt).
    A European put (option) is not the simplest type of derivative, EG, but it is the simplest type of option-style derivative. The simplest type of derivative is (according to every definition I have ever seen) is a vanilla forward and, in the absence of another, non-standard definition of what a derivative is, it remains so.
    .
    If you wanted a description of how an option contract contributes to financial system stability, perhaps you could have indicated that is what you wanted.
    As I am always happy to help, I will do so.
    OK – this is not a difficult example, but it may take a few words.
    Bank A wants to lend some money to Country B, a country with a notoriously unstable history of repayment, but who is willing to pay high interest to compensate for that risk. Bank A has its primary operations in Country A, and its main currency risk is also there. It therefore knows that it really should have the currency component of the risk priced in currency A, rather than currency B.
    Bank A could take out a forward contract for the currency risk, but it knows that it may not get paid by Country B and so, if that happens, it would have a substantial open currency risk.
    The solution to this should be obvious – a vanilla currency put option would be an easy one (a swaption would be better, but let’s keep it simple) as the option allows them to not deliver if they do not receive the money from Country B.
    So, Bank A’s risk is reduced by the use of an option, where it may have actually been increased by the use of the forward contract.
    But, of course, the seller of the put option is getting a raw deal, huh? Not necessarily. They can put in place a call option with a person that is say, exporting from Country B to Country A at a slightly different strike price that results in very little exposure to them.
    Net result? Financial system risk has been reduced and, in the real economy trade is improved. Country B also get a credit line it may not have otherwise received.
    Good all round.

  14. Andrew R. I don’t have to correct myself, whether you like it or not. You still give examples of what is possible assuming that the financial system works. (Rest assured I know all this. Perhaps I should mention that I taught Finance subjects across all levels, including post-grad at the School of Banking and Finance, UNSW, for 8 years and I do live in the real world and therefore have access to publicly available information and I do still have contacts with some of my previous students who work in the finance industry. I hate to write this but it seems this is the only card I have left to stop this discussion. This discussion is at best tangentially relevant to the thread – ie background information.) The question of the conditions under which the financial system works, the way you require for your illustrations, and the stability of such a system requires different methods. I suggest you continue reading Prof. Quiggin’s threads. Every so often he has something on stability issues.

  15. “Bank A wants to lend some money to Country B, a country with a notoriously unstable history of repayment, but who is willing to pay high interest to compensate for that risk.”

    The loan ought not go ahead. Simple as that. This is an example of a bank destroying wealth. Governments who might rightly take a loan would be one whose budget, net of infrastructure spending, was strongly in surplus. But the infrastructure spending brings it into medium term deficit. Thats a good loan. Most loans to government are bad loans. Loans that would not be made were the banks authentically working under a free market, and unable to create new money.

    Wealth creation through debt, for the most part, is where loans are made with the clear and present danger of improving cash flow. At least cash flow after interest, perhaps not including principle repayments. If this is not what is going on most of the time this is wealth destruction. We’d be better off chartering a socialist bank if you guys are not capable of putting your house in order.

  16. @Graeme Bird

    Apologies for the late acknowledgement. I didn’t see your post @28 until now. Its so far up the thread now that it might be useful to copy an excerpt. You wrote:

    “I would have thought a more credible option would be to default on the debt and off balance sheet financing that was not made public (if indeed you are right). That would penalise the financiers that provided the funds that were provided in a less than transparent manner and show that the new government was determined to clear things up.”

    There is an article in yesterday’s Australian Financial Review reporting on talks in the US about the Goldman-Sachs Greek deal. This article provides further information on the inadequacy of the financial reporting system to the extent that information on the exact nature of the deal is still not public. There are also concerns about who knew about what when and who prevented disclosure to whom at the time of the AGI bailout. As a consequence of lack of adequate financial transactions information, it isn’t possible to work out the effects of any default, not even approximately. It is a right-royal mess.

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