European Commission Forecasts for Greece. Source: European Commission
European Commission Forecasts for Greece. Source: European Commission

On the very day Germans voted for a new government last month, a team from Greece’s international creditors was visiting Athens amid the widespread expectation that a new aid package would be needed, including debt relief.

The International Monetary Fund has said so, and even Germany’s austerity-minded finance minister, Wolfgang Schaeuble, acknowledged in the heat of the election campaign that Greece will need more help.

Since Chancellor Angela Merkel’s impressive victory at the polls, however, a push-back has begun, most recently from Klaus Regling, the managing director of Europe’s bailout fund, the European Stability Mechanism. He argued in an interview last week that by now the maturities on Greek debt are so long and the interest rate it pays so low that the scale of the debt pile itself has become “meaningless.”

This is a new and more sophisticated twist to the usual argument against debt relief, which is that forgiveness risks encouraging chronically undisciplined countries to again run up their budget deficits, safe in the knowledge that whenever debts get out of control they won’t have to pay. Both the old and the new arguments are wrong and fraught with risk.

Greek Depression

The expectation that debt relief should follow the German elections was based on a number of immovable facts. The first is that Greece is in the grip of an economic depression that has lasted six years, wiping out 30 percent of its gross domestic product -- the same contraction the U.S. suffered during the Great Depression. Greece is bleeding profusely. The second fact is that after four years of austerity measures designed to reduce Greece’s public debt, it has instead continued to grow to 175 percent of GDP. This is despite the 2012 restructuring of bonds held by the private investors, which shaved 30 percent of GDP worth of debt from what Greece owes.

The bulk of Greek debt is now in the hands of official creditors, and many thought that with elections in the rearview mirror Germany would show some flexibility -- after all, Merkel strongly opposed the private sector restructuring until she turned around and made it happen. In brief, the time has clearly come for creditor countries to forgive part of Greece’s debt, because nobody believes that the government can bring it to a sustainable level on its own.

Regling said in his interview that Greece already enjoys concessional interest rates and long maturities on its debt that amount to a form of relief -- and this is true. Last year, the average maturity of Greek debt was extended from about six years to 16 years, as a combined result of the private sector restructuring and new loans from the ESM. The annual interest rate that Greece has to pay on these new loans is low, about 3 percent. By contrast, Greece pays about 10 percent on its remaining private sector loans. All of this implies a subsidy, because Greece could never have borrowed on such conditions in the open market, to which it has lost access.

Yet whether Greece can pay the interest on its loans for now is not the issue. Greece’s problem is that absent relief, the debt will remain huge. By forfeiting commercial profit on its loans, the euro area is helping out, but these cheap loans still add to the public debt. Japan is one of the few other countries to have amassed such high levels of debt in modern times, and its “lost decade” is now in its 23rd year.

Until Greece’s nominal GDP growth, currently sharply negative, rises above the interest rate it pays on its debts, these will go on increasing as a proportion of the economy. This is simple arithmetic: Debt service costs add to the debt, the numerator, faster than GDP, the denominator, rises.

Market Rates

High debts hurt in many ways, including by making government finances highly sensitive to interest rate movements. One day, hopefully, Greece will recover market access and will face market rates -- these will be substantially higher than the current concessionary rate of 3 percent. Suddenly, the relatively benign arithmetic that is keeping Greece’s debt repayment costs in check will become threatening again. That means raising taxes, which always create growth-unfriendly distortions.

Naturally, official forecasts are predicting that nominal growth will exceed 3 percent by 2015. Perhaps it will, but since the start of the crisis such forecasts have proved little better than wishful thinking, as the accompanying table shows. It aligns European Commission forecasts at the time when the two existing Greek bailout programs were adopted, with actual outcomes. The gap between plan and reality is enormous and has erred consistently on the side of optimism.

The commission’s growth forecasts were important, because they were used to design the Greek bailout programs and the associated conditions that the government in Athens was required to meet. Greece’s failure to meet program targets partly originates in the unrealistic nature of the forecasts, which the IMF has now recognized.

The optimistic view that low interest rates make debt relief unnecessary follows in the same misguided vein. Greece is spending about 5 percent of GDP to service its debts, forcing it into the same vicious circle as Japan (which spends only 2 percent of GDP on debt service) and Italy (5.4 percent of GDP). This burden makes the task of turning Greece’s budget deficit into a surplus hopeless and undermines future growth. Flat growth and no inflation mean that the 3 percent interest Greece is paying on its debt remains too high to reverse the vicious circle that has bedeviled the commission’s forecasts.

After two decades of misery, Japan has decided to go for inflation, and the world is cheering. By now it should be clear that bleeding a country is not the smartest way of establishing fiscal discipline in the euro area, either. It is true that debt relief could prove contagious, but the answer to this objection is: “Yes, and so it should.” Greece is not the only euro area economy saddled by an unsustainable public debt.

Greece needs a debt relief package soon or its only option will be inflation, which means leaving the euro area. Even if this is a pessimistic view, it is a very real risk. Merkel must now weigh that risk against the political cost of reversing herself.

(Charles Wyplosz is a professor of economics at the Graduate Institute of International and Development Studies in Geneva.)

To contact the writer of this article: Charles Wyplosz at charles.wyplosz@graduateinstitute.ch.

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net.