N Chandra Mohan: Unravelling the Greek tragedy

A debt overhang can last generations

The recent elections in Greece and France have sent out a clear signal that the austerity regime foisted on the euro zone’s debt-ridden countries is unacceptable to its people. Around 70 per cent of Greece’s electorate rejected the harsh spending cutbacks required under the bailout package of the “troika” — the European Commission, the International Monetary Fund and the European Central Bank. The new socialist President of France, Francois Hollande, has been talking of a growth strategy to complement the fiscal compact to revive the fortunes of the euro-zone economy, now experiencing zero growth.

Although Greece accounts for only 2.3 per cent of the euro zone, the prospects of fresh elections in June and heightened risks of an exit from the euro currency is bound to trigger panic, capital flight and disorderly defaults in other indebted European countries like Spain and Portugal. Professor Kenneth Rogoff of Harvard University told The New York Times that “it’s not clear how they can survive within the euro over the longer term”, adding that a “Greek exit would underscore that there is no realistic long-term plan for Europe, and it would lead to a chaotic endgame for the rest of the euro zone”.

There are no soft options for Greece, whether or not it remains in the euro zone. The casualty of a prolonged, two-decade long phase in which Greece’s level of public debt exceeded 90 per cent of its GDP for five years or more (1993-2011), has been the country’s economic growth. According to the latest numbers, it will be a fifth lower than the pre-global crisis levels of 2007. Unemployment is at a record level of 21.7 per cent. The rate of joblessness among new entrants is much higher, at 53.8 per cent. Bailout fatigue is understandable as the government still managed to reduce its deficit in a recessionary environment last year.

Greece has had three prior episodes of public debt overhang, according to a paper titled “Debt Overhangs: Past And Present” by Carmen M Reinhart, Vincent Reinhart and Kenneth Rogoff (National Bureau of Economics Research Working Paper 18016, April 2012). These were 1848-1904, 1887-1913 and 1928-1939. If the current phase is also included, 56 per cent of the years between 1848 and 2011 had public debt-to-GDP ratios higher than 90 per cent. These economists also provide averages of real GDP growth and real interest rates for the periods when the debt-to-GDP ratio was below and above 90 per cent.

Growth during public debt overhang episodes with debt-to-GDP ratios above 90 per cent was three per cent per annum, or 1.7 per cent per annum lower than growth registered over the period for which its debt-to-GDP ratio was less than 90 per cent. This is hardly modest considering the fact that the average duration of the four public debt overhang episodes was 23.75 years. Over this prolonged period, “the cumulative shortfall in output from debt overhang is potentially massive” — at close to a third of GDP compared to otherwise in the case of Greece, according to the data of this working paper.

According to textbook economic theory, the connections between public debt overhang and slower growth come from the risk premiums. Countries that are over-indebted can access funds from the market only at higher and higher interest rates. The latter, in turn, has negative implications for investment, consumption of durables, housing and GDP growth. All the four public debt overhang episodes in Greece exemplify this association with higher real interest rates and resultant slower growth. If interest rates exceed growth rates, the public debt-to-GDP ratio snowballs to unsustainable levels.

Greece is only one of the 22 advanced countries that are the focus of this working paper. The three economists delineate 26 debt overhang episodes, 20 of which lasted more than a decade. Their new finding is the duration of the average debt overhang episode, which works out as 23 years across the 26 cases. This is contrary to the popular belief that debt build-ups happen during business cycle downturns or recessions. As in the case of Greece, slower growth associated with public debt overhang over this period cumulates into a shortfall of a quarter of output. However, in three cases, high public debt was associated with higher GDP growth: Belgium (1920-26), UK (1830-1868) and Netherlands (1932-54). And again contrary to expectation, in 11 of the 26 cases, high debt periods went with lower or comparable interest rates and lower GDP growth.

What is to be done for Greece? Although the authors of this working paper state that their findings should not be taken as a manifesto for “rapid public debt deleveraging in an environment of extremely weak growth and high unemployment”, the austerity regime imposed by the troika attempts to do just that. Spending cuts will only impair its growth. Instead of austerity, what Greece badly needs is for its growth to be revived so it can grow out of its debt problem. Whether this can happen within the framework of the euro zone, according to President Hollande’s growth compact, or out of both will be seen in the months ahead.

 

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