Fear is growing that Greece — one of 16 countries that use the euro as currency — may default on a massive pile of debt, creating a ripple effect of problems throughout Europe and beyond. Following pressure from the European Union and the European Central Bank, the Greek government on March 3 announced a new round of austerity measures — the third such package in the last six months. It includes a freeze on pensions and additional wage cuts for government workers. In addition, the top rate of the country’s value-added tax will be raised from 19% to 21%, and excise taxes on alcohol, cigarettes and fuel will be hiked for the second time in two months. Leaders of public-sector labor unions reacted with outrage to the measures, saying they will harm Greece’s economy; some unions vowed to stage strikes later this month.
Meanwhile, Wall Street banks are again facing scrutiny — this time, for the complex financial instruments they used to allegedly disguise the country’s real debt. What caused Greece’s debt problem to spin out of control? And what steps should it take to remedy the situation? Wharton finance professors Richard Herring and Itay Goldstein weigh in.
A transcript of the conversation appears below.
Knowledge at Wharton: Let’s discuss some background first before we get into the measures that Greece should take to help itself. How did Greece get into this predicament? Was it a long time coming or not?
Richard J. Herring: Yes. And it’s really a very old-fashioned kind of crisis. It is a throwback to the kinds of crises we had in the 1960s when we had a fixed exchange rate system in the world, and the countries we were bailing out then were the U.K. and Italy, but we didn’t worry so much about the less developed countries because they couldn’t borrow it all. In the case of Greece, Goldman is getting a lot of publicity they would rather not have for this.
Knowledge at Wharton: Goldman Sachs, that is.
Herring: Yes, Goldman Sachs. There was a little help in aiding the Greeks in achieving the entry requirements into the eurozone. The Maastricht Treaty set out some very strict requirements for convergence. You were supposed to have a budget deficit no more than 3% of GDP, and I think outstanding debt no more than 50% of GDP. The Greeks didn’t quite have that situation. But with a little help from Goldman they could reclassify debt as a forward exchange contract and they looked okay. Now, this was a wink-wink, nod-nod sort of agreement with the Europeans. I don’t think anybody was fooled at the time because the Europeans were desperate to get Greece into the Union so that it wouldn’t fall back into the hands of a military dictatorship. They thought it was an affront to Greece and to the world that the cradle of democracy should have been controlled by a military dictatorship. So there were lots of reasons to make it a little easier for Greece to get in.
The irony is that the ruse that was used is something that was invented in Europe at the very beginning of modern banking. At the beginning of modern banking it was not only illegal, but a mortal sin to lend money for interest. And so everybody wanted to disguise debt, but there was a need for debt, just as there is today. So they disguised it in foreign exchange transactions. It was not illegal to charge for moving currency from one place to another or from one currency into another. And that is essentially what the swap does. It is not a new technique. It has just got some additional bells and whistles on it.
And what Greece has done is sort of run into the iron law of international finance, which is that everybody would like to have an independent exchange rate policy and an independent monetary policy, and an independent fiscal policy. But it just doesn’t work. You can only pick two of the three. And by joining the euro, they have picked two. They have pegged their exchange rate and they are stuck with European central bank monetary policy. That means they really have to use their fiscal policy to stay within the parameters that will keep them in the euro system. It is a lesson that has rung true for centuries, actually. But some countries can actually do it. And Ireland is maybe an interesting example.
Knowledge at Wharton: I’m going to ask you about Ireland shortly, so let’s hold off on that.
Herring: Another one is Latvia, which actually reduced prices internally. An exchange rate really is a mechanism for equating internal and external prices so they are once again competitive, and Greece is really overvalued relative to the rest of the euro community right now. So if they could run austerity long enough to take the crisis down, they could make the adjustment. But there’s a real question about whether they have the political will, the political support, or even the tools to do it.
Knowledge at Wharton: Itay, do you have anything to say in response to what Dick just discussed?
Itay Goldstein: In general, I agree. I think what happened was a simple debt swap around the time that they wanted to join the European Union. Artificially, it looked like the debt was lower than what it is. It is kind of similar to the off-balance sheet debt that we saw in some of the corporate crises in the U.S.
Herring: We should remember that this happened in 2001, and it was before the Enron explosion.
Goldstein: It was before that, right.
Herring: It was before that. And it was really sort of considered the mission of banks and investment banks to help corporations and sovereigns fool their creditors…. It was just an accepted fact — “that’s part of what we do.”
Goldstein: And I think that other countries did that, too, around that time.
Herring: Yes, they were not unique.
Knowledge at Wharton: Is there also something more fundamental at work? Was the government of Greece simply, over a period of years, spending way too much money, whether it was in the form of wages to workers or pension benefits, or other government expenditures? Were they living beyond their means?
Herring: Yes, because they were incurring account deficits consistently throughout and that is the measure of whether you are living beyond your means. As are we, I might add. And there comes a day — and I’m not sure when ours is coming — but that can’t go on indefinitely.
Knowledge at Wharton: Let’s talk a little bit now about the austerity measures that Greece is apparently going to announce on March 3, which is the day after we are recording this conversation. The online edition of The Wall Street Journal reported today that on March 3, Athens would announce an austerity package of about $5 billion to cut its budget deficit this year, and according to the paper the package was likely to include an increase of two percentage points in the value added tax, which is currently about 19%. Also reportedly part of the packager are: more cuts in civil service entitlements; a freeze in pensions; and higher duties on luxury items like boats and expensive cars, and that sort of thing. The Journal also said the government had plans to issue a 10-year note to raise as much as $6.7 billion to give it some cash. We don’t know what is going to happen tomorrow or the next day. But given that report in the paper, would both of you think that these measures are sufficient? Does it sound like a good step — or not enough?
Goldstein: It certainly sounds like a good step. I think the uncertainty is whether they will be able to actually put it through, like Dick said. I also hear that there is a strike that is planned by the civil servants, and the question is whether they will actually have the political power to go all the way.
Herring: Even before this came to the fore, the Greeks were striking and rioting over the slowness of the increases in wages and benefits and such. It is a very unionized country with a very rigid labor structure. There are lots of restrictions for entry into certain kinds of professions. So, I would guess that [Greece] is going to have a much harder time making these kinds of internal adjustments than Ireland apparently has. It is a plan that has all the right words in it, but I don’t think anybody is going to run out and buy group plans on the strength of it. I think they are going to wait and see how it actually plays out.
Knowledge at Wharton: What does that mean, then? Does that mean that Greece will be in greater danger of default if the market perceives that these measures are not sufficient?
Herring: I think it depends on the kind of backup they get from the EU. The EU is tying itself in knots trying to figure out how to support the Greeks without violating their own rules. You have such bizarre behaviors as asking their banks to buy more Greek debt, but guaranteeing it with government-owned banks so it isn’t directly state aid — although from a taxpayer’s point of view, I don’t see quite how to make the distinction. But both the French and Germans are talking in that direction. And, you know, certainly in the case of Greece, they could amass enough to convince speculators that it was solid. But that is a very slippery slope, because [while] they can do it for Greece, they probably can’t do it for Spain. They surely couldn’t do it for Italy. Portugal, maybe. But once you set the precedent, it is just very hard to know where to draw the line. I think they would have been much better off leaving it to the IMF to apply an old-fashioned IMF program, just as if [Greece] weren’t a member of the EU.
Knowledge at Wharton: And why hasn’t the IMF been involved?
Herring: I have the impression that the EU has not wanted them interfering in EU affairs.
Goldstein: Yes. I think part of the concern is if there is no intervention, then speculators might go after other countries as well — like Ireland or Italy or Spain. This is why there is a little bit of pressure to sort of intervene. I think you are right. They probably don’t want the IMF to get into EU business.
Herring: Well I think there are some hidden politics involved, too. Dominique Strauss-Kahn, head of the IMF, I think aspires to be head of the EU at some point in time. That is yet another bit of tension between the two institutions that might not otherwise exist.
Knowledge at Wharton: Because Greece is a member of the eurozone and uses the euro as its currency, does that matter going forward for the other countries of the eurozone? What is the worst-case scenario that could happen that would affect other countries using the euro?
Goldstein: Greece itself is probably small enough that this may not have a direct effect on the eurozone in general. I think that in the background, the fear is really about contagion — that once one country goes down, other countries will follow. And you can think about the various mechanisms [at play here, including] the type of guarantees that are provided. If Greece is not provided with guarantees, then other countries might not be provided with guarantees, and then speculators will find it easier to go there.
Herring: I guess I would mention two other aspects, although I certainly agree with you entirely. One is its impact on the accession states that are trying to decide whether or not to join the Euro. You have already seen in opinion polls that the problems that Greece is having have persuaded a number of voters that they don’t want to go [in the same direction]. They would still like to be in the EU, but not part of the currency.
The other thing that we don’t know the magnitude of — which is a lot more worrying, actually, and could lead to a double dip recession even in the United States — is the amount of Greek securities that the European Central Bank has accepted as repos. We know they were doing massive repos.
Knowledge at Wharton: Repos are?
Herring: It is where banks will give them a sovereign bond and they can in turn get cash. Because even then the Greek bonds were cheaper than the [most comparable alternatives,] everybody repoed their Greek bonds. So it may be that the Central Bank is sitting on much of the credit risk. We just don’t know. They haven’t opened their books to tell us. And that could lead to some longer-term problems for the euro. Simply the fact of potentially losing a member casts doubt on the permanency of the whole arrangement. After all, history has not been kind to this kind of union. I think the longest one that ever lasted was twenty years? So it would be a blow to the aspirations of the euro to become the international currency to displace the dollar.
Knowledge at Wharton: Are there officials in Britain, for instance, who are glad that the U.K. did not join the Euro when it had a chance?
Herring: Well they have problems of their own, I think. They would be worse off had they joined the euro.
Knowledge at Wharton: But is this a vindication of that school of thought — that joining the eurozone was not a good idea from the get-go?
Herring: I think from their point of view, it probably is because the dynamics of their economy is so much unlike that of the other large economies in Europe that it would never have been quite the right exchange rate for them.
Goldstein: Greece is an example of why joining a monetary union could be a problem, because they certainly would have more flexibility to deal with the crisis if they were on their own to value the currency. Now, they are basically locked in a situation where the only tool that they have is fiscal policy.
Knowledge at Wharton: Should Greece have been admitted to the eurozone at all?
Herring: That’s a hard question, because it is fundamentally political. Trying to place Greece firmly in the camp of democratic countries is good for Western culture at large, so I wouldn’t want to answer it on purely economic grounds. I don’t know that joining the euro has done good things for the Greek economy. It has let them borrow at much, much lower rates than they otherwise could, but that has probably led to excessive leverage, which has put them where they are now. But it was yet another way to tie them into the European venture.
Goldstein: I certainly agree. Economically, this was certainly not the most natural thing to do. But this was a political decision. To answer this question fully, you have to go back to why [countries] wanted to have the European Union in general, and I think a lot of it was just politics.
Knowledge at Wharton: Are there other countries at risk of following Greece down this path? For instance, Dick, you already mentioned Ireland. There was an item in The Wall Street Journal a day or two ago about Japan facing up to the challenge of its massive debt. We all know the massive debt of the United States. You also mentioned Portugal. Put this into context. Is the Greek crisis, which followed the Dubai crisis a few months ago — [does it all suggest] we are in a period of semi-permanent instability in terms of government debt?
Herring: Well, [we can] assume the National Bureau of Economic Research will tell us we are officially out of the great recession, but it doesn’t feel like it…. And I think there is a real question about whether we may have a double dip in the United States, because the household sector has not successfully deleveraged and it is usually the engine of growth and spending in the United States. If we should be hit by a shock to Europe, as I think a Greek default could cause, it would be almost a sure thing [that we are] headed for a double dip.
I certainly wouldn’t put Japan in the same category as these countries. Japan is a very serious long-term problem, partly because the age structure of its citizens, but they have huge reserves — the third-largest in the world, or the second-largest perhaps. They are really not, at this point, in any real jeopardy. Their problem is to try to figure out how to sustain an aging workforce without a growing population and without immigration, which could save them. But it is culturally very hard for them to do.
In the case of Greece, I think there is one other thing we have left out, which may be important. And the question is, how much can the central government actually control? It is a very decentralized country, fiscally, and a lot of the debt is run up by the regions. The central government has no real impact on them, so the part of the deficit that the government can actually control from one year to the next is relatively slight, which makes it particularly vulnerable.
Ireland is an interesting case, because they have put in place a remarkable austerity program. It is really scary in terms of its aggressive cut of just about everything — yet, surprisingly, the Irish population has bought into it. But I think another thing these countries had in common — and I put Spain in this same box — is that the interest rate policy that turned out to be the Euro interest rate policy was much too low for each of these countries. Had they been on their own, they would have had a much higher interest rate and, therefore, they would not have leveraged themselves nearly as highly as they did.
Knowledge at Wharton: They just would not have been able to borrow as much money.
Knowledge at Wharton: Let’s talk a little bit more about the role that derivatives played in masking a portion of Greece’s debt. How do these derivatives work, and how were they used in the case of Greece? What exactly happened here?
Goldstein: I don’t know those derivatives inside and out. Essentially, this was just a debt swap. You have debt in one currency, and you swap it for debt in a different currency. Depending on the exchange rate, you can basically reduce the amount of debt that is shown on the balance sheet, but then it is kind of being replaced with a liability that you will have to pay later on. This is off the balance sheet, and I think that our listeners are probably aware of what happened in the U.S. with firms like Enron and others. It is very similar to that — only for countries rather than firms — in the sense that you have liabilities that are off the balance sheet.
Herring: The interesting thing is that Eurostat, which is the official keeper of records for European countries, apparently sanctioned it and was well aware of it. It is less clear that the buyers of the debt were. The other thing that has worried people a lot is the credit default swaps. I would say at this point that the two most hated instruments — and this turns out to be true whenever anybody gets in trouble — are short sellers of the currency and credit default swaps. It is sort of like blaming the messenger for the message. It is an economically efficient and convenient way for people to vent against the government or the current policies, and governments naturally don’t like it. But it is not at all clear that it is causing the problem at all. It may speed things up a bit, and for that reason it may keep them from getting worse than they otherwise would have done.
Goldstein: I think that the credit default swaps came into the picture later, in this current episode. Basically, what is going on now is that banks that think that Greece is likely to default on its debt are buying a lot of credit default swaps. And these credit default swaps basically entitle them to get money if Greece indeed defaults on the debt, or renegotiates or whatever. It is a way to kind of bet against the country — just like with short selling, you can bet against a firm.
Herring: That actually brings in the third “bad man” that all governments hate, and that is the hedge funds, because the hedge funds apparently did buy a lot of credit default swaps a year ago. They saw this coming much faster than the banks did, and they are now selling them at fairly handsome mark-ups, and are making a lot of money from [doing so].
Knowledge at Wharton: Is this just like criticism of short selling during our own crisis back in 2008 and early 2009? Is it right to criticize hedge funds for making a profit off the misery of a country like Greece?
Herring: I wouldn’t say they were making [a profit] off the misery of a country like Greece. They were forcing the country to face up to the set of facts that they were unwilling to confront. [Similarly,] if you look back at the evidence from stopping short selling at all of the U.S. banks, we made things worse for them because the liquidity in those markets dried up. None of them were saved. In fact, it probably prolonged their agony.
Knowledge at Wharton: But that’s the way it is often portrayed, is it not?
Herring: Oh, absolutely. It is easy. The easiest thing for a politician to do is to rant about hedge funds, short selling and credit default swaps. And you can count on cheers for every single one of those.
Goldstein: I certainly agree with Dick that short selling and credit default swaps serve some positive role. But one has to remember that in some cases, they can bring a self-fulfilling prophecy. Suppose [for example] that people think that the Greek government is likely to default, so they start buying those credit default swaps. The price goes up, indicating that a crisis is likely to arise, but this makes it then even more difficult for Greece to get new debt, and this makes the crisis more severe. And I think this is the kind of mechanism that policymakers had in mind when they were worried about short selling.
Herring: But look at what the alternative would be. If you held that view and were not permitted to use swaps, then you could easily do it with the debt. [Swaps are] just a more efficient way to do it. I agree with you that [swaps are] subject to manipulation with regard to small corporations, where hedge funds have very large resources relative to the size of the market and they can play games with them in that event. But when we are talking about a major bank or a country the size of Greece, it is much less plausible.
Goldstein: I think it is much more difficult. But we are still looking for evidence, I think, which is hard to find.
Knowledge at Wharton: One final question, maybe in two parts. One, I want to know from both of you whether you are optimistic or pessimistic about Greece’s chances of getting its debt under control and moving forward. And, secondly, what do you think will happen in the short term? In the days and weeks to come, what are we likely to see in terms of additional austerity measures, the reaction of markets to the austerity measures, and the reaction of pensioners and municipal government employees in Greece?
Herring: I think that question has an obvious answer: We are going to see a lot more unrest. We will see many more strikes. We will see lots of public unhappiness. There is nothing pleasant about tightening your belt. Whether the Greeks have the political culture and fundamental legitimacy for the current government to successfully implement these measures, I am afraid is sort of an open question. I hope they do. It is much better for everybody if they do. But it is not an especially placid population. On the other hand, I would have said that about the Irish, too, and I was dead wrong.
Goldstein: I agree. It is an open question. There certainly will be a lot of unrest. Eventually what will happen depends on what happens in other countries. It depends on what will happen with the recession in Europe and in the U.S., and whether Greece will be able to get the backup that it is hoping for.
Herring: In that regard, the silver lining as far the Europeans are concerned is that they are going to lag the U.S. in raising their interest rate, and they are hoping that will drive down their exchange rate and make exports an engine of growth for Europe as a whole. Now whether that helps Greece a lot is not so clear, because they don’t really play in that market in a big way. But for the rest of Europe, it may be very good news indeed.