Greek Default

By James H. Nolt

Much attention is being lavished on the Greek government’s default Tuesday on its debt to the International Monetary Fund (IMF). Unfortunately, like most economic events, it is shrouded in uselessly vague phrases and excessive scrutiny of superficial aspects, such as whether Greek officials wear ties.

What very few of the media commentators are discussing is the responsibility of the creditors. All debts are contracts between two parties. If Greece borrowed “irresponsibly,” that was only possible because creditors lent irresponsibly.

The Maastricht Treaty that created the euro as the currency of the European Monetary Union (EMU) included limits on government debt and deficits. The ratio of government debt to GDP was supposed to be no more than 60 percent. A few euro zone countries, including the largest, Germany, had around this level of debt until the world financial crisis hit in 2008. Others, such as Greece and Italy, entered the EMU with debt levels of over 100 percent of GDP that would shoot up further during that crisis. By 2011, Greek debt was triple the EMU target.

The private banks and multilateral institutions that underwrote Greek government bonds had the responsibility to price Greek debt accurately, reflecting the risk of default on that debt, taking into account the size of the Greek economy, its growth prospects, its political stability, etc. Furthermore, the various public and private investors who bought Greek government bonds should have been aware that there could be risk of default, as indeed all savvy investors know.

Yet nearly all commentators talk as if the problem is entirely Greece’s bad behavior rather than the reckless underwriting of risky debt by EMU bankers and bureaucrats for their own reasons.

Following the 2008 crisis, the European Central Bank (ECB), like the U.S. Federal Reserve, began a program misnamed “quantitative easing” (QE), which greatly stimulated demand for euro bonds, keeping their prices high and their yields (interest rates) low. QE is misnamed since it is supposedly expanding the money supply, but what it actually involves is massive central bank bond purchases, which does raise bond prices and thus keeps government borrowing costs low.

According to the economic theory of QE, this massive bond buying puts cash in the hands of the public, stimulating more spending on products and services, but that is not necessarily the case, since most bond owners are rich people, corporations, and governments. They may simply sell government bonds at a high price in order to buy some other financial asset. Government subsidies to the rich and powerful to rearrange their portfolios do not necessarily help ordinary folk. QE did certainly make it easy for all EMU governments, not just Greece, to sell bonds on an ever-expanding scale.

The current Greek government, elected only in January this year, was not directly party to this profligate financing of government spending with debt. It is no wonder that the Syriza coalition government authorities are frustrated that the cost of excessive borrowing is being thrust onto vulnerable retirees, public employees, and ordinary Greek citizens who had little voice in the decisions on how to finance Greek budgets. Why shouldn’t investors who bought the risky debt share the cost for their own bad decisions?

Media coverage is alarmist in suggesting that this is completely unprecedented and unbalanced in blaming the debtors but largely ignoring the large responsibility of the European creditors who facilitated this course.

This event is new and unprecedented not because a government is defaulting on its debt. Nearly all national governments have defaulted on debt at least once. Several have defaulted ten or more times in recent centuries. Greece has defaulted on debt several times in the past, though it is not among the most chronic in this regard.

What is new is that Greece is the first country to default on euro debt. (Some would say it is the second, since tiny Cyprus delayed some bond repayments in 2013.) The euro has functioned as the currency for most European Union members (19 so far) for about a decade and a half.

The euro is somewhat unprecedented in world history, because it is the contemporary world’s most important experiment in currency unification among otherwise largely independent nations. Usually national power and currencies go hand in hand.

Divorcing currency from government creates a potential problem. Governments may be tempted to borrow and spend without regard to the consequences on the value of the currency if the currency serves a much bigger region beyond their responsibility. Recognizing this potential problem, the Maastricht Treaty included debt and deficit caps, though since 2008 these have been universally exceeded.

This problem is not so unusual either. Local governments in many countries, including the U.S., have borrowed abroad for centuries, even though these local governments do not control the national currency. When local governments default on debt, as they often have through history, it rarely implies that those localities will be excluded from using their nation’s currency. Yet in this crisis, nearly all commentators are assuming that default means Greek exclusion from the euro zone. This is certainly not an automatic consequence of default, but would occur only by policy choice. It is a power ploy.

This week, the governor of Puerto Rico also announced that the American territory must also default on its debt, but nobody seemed to believe this would result in its exclusion from the U.S. dollar zone.

While most stories about the crisis are framed in terms of Greek misbehavior and its expected consequence – shunning from the EMU – this would be an unusual sanction if it does come to that. Throughout history the typical sanction for bad debts is reduced willingness of creditors to finance future borrowing, which shows up as higher interest rates on future borrowing.

Remember, as we have discussed in earlier blogs, large debtors, like governments, do not typically borrow the way ordinary people do, by seeking a loan from a bank. Most sovereign debt is in the form of bonds (if long term) or bills (if short term). Most often, debts are not paid off when the bonds or bills come due, but simply refunded or rolled over. In other words, new bonds are sold to investors to raise funds to pay off the old ones.

When governments keep expanding their debt faster than their economies are growing, then year after year as old debts come due, an ever-increasing number of bonds are sold. Nobody is forced to buy these bonds. They are sold at flexible market prices. But the normal expectation of investors is that if debt expands much faster than income, eventually it will reach a level that risks default. Therefore, debtors issuing too many bonds eventually find them to be harder and harder to sell, reflected in their lower price, or greater discount.

What is most odd about the current Greek crisis is the extreme roller coaster ride Greek bonds have had. This suggests that this crisis is a power struggle between bears and bulls. In financial wars such as this, the suffering of the Greek citizens is merely the collateral damage from a struggle between rival investment positions. I will explore this more next week.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.