Germans Forget Postwar History Lesson on Debt Relief in Greece Crisis

7/7/2015

By  Eduardo Porter

As negotiations between Greece and its creditors stumbled toward breakdown, culminating in a sound rejection on Sunday by Greek voters of the conditions demanded in exchange for a financial lifeline, a vintage photo resurfaced on the Internet.

It shows Hermann Josef Abs, head of the Federal Republic of Germany’s delegation in London on Feb. 27, 1953, signing the agreement that effectively cut the country’s debts to its foreign creditors in half.

It is an image that still resonates today. To critics of Germany’s insistence that Athens must agree to more painful austerity before any sort of debt relief can be put on the table, it serves as a blunt retort: The main creditor demanding that Greeks be made to pay for past profligacy benefited not so long ago from more lenient terms than it is now prepared to offer.

But beyond serving as a reminder of German hypocrisy, the image offers a more important lesson: These sorts of things have been dealt with successfully before.

The 20th century offers a rich road map of policy failure and success addressing sovereign debt crises.

The good news is that by now economists generally understand the contours of a successful approach. The bad news is that too many policy makers still take too long to heed their advice — insisting on repeating failed policies first.

“I’ve seen this movie so many times before,” said Carmen M. Reinhart, a professor at the Kennedy School of Government at Harvard who is perhaps the world’s foremost expert on sovereign debt crises.

“It is very easy to get hung up on the idiosyncrasies of each individual situation and miss the recurring pattern.”

The recurring, historical pattern? Major debt overhangs are only solved after deep write-downs of the debt’s face value. The longer it takes for the debt to be cut, the bigger the necessary write-down will turn out to be.

Nobody should understand this better than the Germans. It’s not just that they benefited from the deal in 1953, which underpinned Germany’s postwar economic miracle. Twenty years earlier, Germany defaulted on its debts from World War I, after undergoing a bout of hyperinflation and economic depression that helped usher Hitler to power.

It is a general lesson about the nature of debt. Yet from the World War I defaults of more than a dozen countries in the 1930s to the Brady write-downs of the early 1990s, which ended a decade of high debt and no growth in Latin America and other developing countries, it is a lesson that has to be relearned again and again.

Both of these episodes were preceded by a decade or more of negotiations and rescheduling plans that — not unlike Greece’s first bailout programs — extended the maturity of debts and lowered their interest rate. But crises ended and economies improved only after the debt was cut.

In a recent study, Professor Reinhart and Christoph Trebesch of the University of Munich found sharp economic rebounds after the 1934 defaults — which cut debtors’ foreign indebtedness by at least 43 percent, on average — and the Brady plan, which sliced debtors’ burdens by an average of 36 percent.

“The crisis exit in both episodes came only after deep face-value debt write-offs had been implemented,” they concluded. “Softer forms of debt relief, such as maturity extensions and interest rate reductions, are not generally followed by higher economic growth or improved credit ratings.”

Policy makers have yet to get this.

This is true even at the International Monetary Fund, which was created after World War II to deal precisely with such situations. Its approach to the European debt crisis, five years ago, started with the blanket assertion that default in advanced nations was “unnecessary, undesirable and unlikely.” To justify this, it put together an analysis of the Greek economic potential that verged on fantasy.

Even as late as March 2014, the I.M.F. held that the government in Athens could take out 3 percent of the Greek economy this year, as a primary budget surplus, and 4.5 percent next year, and still enjoy an economic growth surge to a 4 percent pace.

How could it achieve this feat? Piece of cake. Greek total factor productivity growth only had to surge from the bottom to the top of the list of countries using the euro. Its labor supply had to jump to the top of the table and its employment rate had to reach German levels.

The assumptions come in shocking contrast to the day-to-day reality of Greece, where more than a quarter of the work force is unemployed, some three-quarters of bank loans are nonperforming, tax payments are routinely postponed or avoided and the government finances itself by not paying its bills.

Peter Doyle, a former senior economist at the I.M.F. who left in disgust over its approach to the world’s financial crises, wrote: “If ‘optimism’ results in serial diagnostic underestimation of a serious problem, it is no virtue: At best, it badly prolongs the ailment; at worst, it is fatal.”

Creditors, of course, do not generally like debtors to write down their debt. But that’s not how Germany and its allies justify their approach. They rely instead on a “moral hazard” argument: If Greece were offered an easy way to get out of debt, what would prevent it from living the high life on other people’s money again? What kind of lesson would this send to, say, Portugal?

But the Greek economy has shrunk by a quarter. Its pensioners have been impoverished. Its banks are closed. That counts as suffering consequences. No sane government would emulate the Greek path.

Germany, in fact, understands moral hazard backward. The standard definition refers to lenders; covering their losses will encourage them to make bad loans again. And that is, let us not forget, exactly what Europe’s creditors have done. Their financial assistance to Greece was deployed to pay back German, French and other foreign banks and investors that held Greek debt. It did Greece little if any good.

Greece has done little to address its endemic economic mismanagement. But it has few incentives to do so if the fruits of economic improvements will flow to its creditors.

A charitable explanation of the strategy of Greece’s creditors is that they feared Europe’s financial system was too fragile in 2010, when Greece’s insolvency first became apparent, to survive a write-down of Greek debts. Greece, moreover, was not an outlier but one of several troubled European countries that might have followed the same path.

But Adam S. Posen, who heads the Peterson Institute for International Economics, says he thinks it has more to do with political cowardice. Greece’s creditors were not prepared to take a hit from a Greek debt write-down and then explicitly bail out their own banking system. So they resorted to what Mr. Posen calls “extend and pretend.”

“There’s an incredibly strong incentive not to recognize losses,” Mr. Posen told me. Governments “will do things that are more costly as long as they don’t appear as a line-item on the budget.”

There is a slim case for optimism. Today, the risk of contagion from Greece is low, Professor Reinhart says. Other peripheral European countries are in better shape. And even the I.M.F.’s economists recognize that there may be no way around a Greek write-down. The cost to Europe’s creditors would be minuscule.

Yet Germany has not come around. It took a decade or more from the onset of the Latin American debt crisis to the Brady deal. Brazil alone had six debt restructurings. Similarly, the generalized defaults of 1934 followed more than a decade of failed half-measures. Does Greece have to wait that long, too?

Correction: July 7, 2015
An earlier version of this column described incorrectly the period of time in which Brazil had six debt restructurings. It was the 1980s and 1990s, not the 1990s.

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