Judy Asks: Can debt relief save the euro?

The question is not whether debt relief is needed, but how and when it will take place.

Almost one year after the Greek debt drama, which almost ended with Greece’s exit from the eurozone, the conflict between the Greek government and its European partners is again heating up. The bad news is that progress on Greek reforms is slow and painful. The good news is that as Greece has become increasingly isolated, the Greek crisis no longer seems a major threat to economic or political stability in the rest of Europe.

On the issue of debt relief: Greece’s public debt is close to 180 percent of GDP as of spring 2016 and likely to rise to close to 200 percent over the next two years. Although the Greek government has received very favorable conditions on servicing its debt, it is realistic that interest rates on Greek debt will rise to 5–6 percent during the next five years. This implies that overall debt servicing costs, including the repayment of the principal, could exceed 15 percent of Greek GDP, which is unsustainable.

The best solution will likely be to grant further debt relief in the form of an extended maturity and transformation of the debt, linking it to growth in Greece rather than in the eurozone area, conditional on the country successfully completing its third bailout program. In short, debt relief for Greece will not save the euro, but nor does it threaten it.

There are four scenarios for the future of the eurozone. The first is strong integration, including fiscal and political union. The second is decentralization, with a strict no-bailout rule, the option for countries to default on their debts, and maximum national policy autonomy. Between those two options is a middle ground in which Europe focuses on the areas that need integrating the most and leaves the rest to individual EU member states. And then there is the fourth scenario of muddling through on the current trajectory, but that is neither economically nor politically sustainable.

Debt relief alone cannot save the euro. Europe’s financial system is not prepared for such a shock—if it ever will be—nor is there enough political will to design orderly debt relief for all member states, for example through a large European debt reduction initiative.

But the case for Greek debt relief is overwhelming. Without debt relief, Greece’s creditors will continue to demand self-defeating fiscal cuts, undermining the recovery and wasting precious political capital on fiscal measures instead of focusing all energy on institutional and political reforms that the country so badly needs.

Debt relief should be a solution of last resort if a country cannot avoid a debt deflation trap without it. This option should be combined with fiscal discipline and bold domestic reforms. It should come with a more integrated Economic and Monetary Union, with mechanisms of risk sharing to render it sustainable.

Greece has shown that mild debt relief, if postponed, can lead to steeper debt relief that becomes inevitable. Greece entered the eurozone crisis through its own reckless fiscal management up to 2009. But the decision not to allow even debt reprofiling in 2010 was a mistake. The cost was the largest combination of bailout loans and delayed debt restructuring (in 2012) and a harsh fiscal consolidation that led to over 25 percent cumulative depression and unemployment.

Locking an economy to a primary budget surplus target of 3.5 percent of GDP for years is not realistic. It is even less realistic for an economy such as Greece’s in steep disinvestment and with an employment rate close to 50 percent, undermining potential growth.

Timely and realistic debt relief in such cases is also a strategy for addressing the risk of disintegration in the Economic and Monetary Union. If the eurozone allows any member to slide toward the exit, it will be impossible to prevent the risk of currency redenomination from spreading to other vulnerable members, becoming a self-fulfilling prophecy.

Although it could be somewhat beneficial to the country’s battered economy, Greek debt relief would not save the euro, simply because the sustainability of debt does not pose a life-threatening challenge to Greece, let alone to the EU. After all, given the concessional terms of the EU’s loans, Greek debt is manageable until 2023.

In the long run, providing some debt relief such as maturity extensions and reprofiling may be beneficial, yet the problem is that any agreement will be linked to utopian primary surpluses that are unlikely to be met as well as austerity measures that are doomed to fail because they envisage ever higher taxes and social security contributions.

The IMF and the EU have engaged in a counterproductive power game vis-à-vis the sustainability of Greece’s debt, based on micropolitical calculations. This showdown has obscured the reality that the biggest threat for the eurozone stemming from Greece—if any—is the country’s unsustainable economic and social model, in tandem with the unwillingness of all sides to bear the political cost and address deep-rooted problems. Even if a promise of debt relief turns out to be more than hot air, it will not be a game changer.

Debt relief should not be seen as a way to save the euro. The EU’s common currency will survive without it, provided that political support in member countries remains robust. However, reducing the debt overhang in some crisis-hit countries remains a necessity to unshackle those economies, put them on a sustainable debt path, and ultimately make it easier for them to attract international investors.

Of course, debt relief on its own would not work if a country refused to fully implement meaningful structural reforms that put its budget back on track and made its economy more competitive. This is a common-sense principle that the German government has insisted on since the outbreak of the so-called euro crisis.

The question today is not whether debt relief, whatever form it takes, will happen. It will, eventually. Rather, analysts should ask whether debt relief is conditional on the completion of ambitious reform agendas or whether it should take place sooner. Can the EU afford to wait until a country has stopped being a risk to its creditors, or are creditors—in the case of Greece, euro area taxpayers—needed to share some of the risks earlier? Observers should stop treating the issue of granting debt relief as if it were some sort of distant fata morgana. The price to pay would be a monetary union condemned to be unnecessarily fragile.