Christine Lagarde, IMF Director, 2013.Demotix/ Omar Franco Perez Reyes.All rights reserved.
On July 2, the IMF released its analysis of whether Greek debt was sustainable or not. The report said that Greek debt was not sustainable and deep debt relief along with substantial new financing were needed to stabilize Greece. In reaching this new assessment, the IMF stated it had learned many lessons. Among them: Greeks would not take adequate structural reforms to spur growth, they would not sell enough of their assets to repay their debt, and they were unable to undertake sufficient fiscal austerity.
That left no choice but to grant Greece greater debt relief and to provide new financing to tide Greece over till it could stand on its own feet. The relief, the IMF, says must be provided by European creditors while the IMF is repaid in whole.
The IMF’s report is important because it reveals that the creditors negotiated with Greece in bad faith. For months, a haze was allowed to settle over the question of Greek debt sustainability. The timing of the report’s release—on the eve of a historic Greek referendum, well after the technical negotiations have broken down—suggests that there was no intention to allow a sober analysis of the Greek debt burden. Paul Taylor of Reuters tells us that the European authorities worked hard to suppress it and Landon Thomas of the New York Times reports that, until a few days ago, the IMF had played along.
As a result, the entire burden of adjustment was to fall on the Greeks before any debt reduction could even be contemplated. This conclusion was based on indefensible economic logic and the absence of the IMF’s debt sustainability analysis intentionally biased the negotiations.
As an international organization responsible for global financial stability, it is the IMF’s role to explain clearly and honestly the economic parameters of a bailout negotiation. The Greeks, many said, benefited from low interest rates and repayments stretched out over many years. Therefore, no debt relief was needed. But, of course, as the IMF now makes clear, if a country has to repay about 4 percent of its income each year over the next 40 years and that country has poor growth prospects precisely because repaying that debt will lower growth, then debt is not sustainable. If this report had been made public earlier, the tone of the public debate and the media’s boorish stereotyping of Greeks and its government would have been balanced by greater clarity on the Greek position.
But the problem with the IMF report is much more serious. Its claims to having learned lessons from the past years are as self-serving as its call on other creditors to provide the debt relief. The report insistently points at the Greek failings but fails to ask if the creditors misdiagnosed the Greek patient and continued to damage Greek economic recovery. Protected by the authority and respect that the IMF commands, it is easy to lay the blame on the Greeks whose rebuttals are treated as more hysterical outbursts of an (ultra) “radical” government.
The creditors’ serial errors are well documented, including by the staff of the IMF. Continuing deliberately to suppress past errors is an act of bad faith but continuing to repeat those errors in making future projections of the Greek debt burden is a willful abuse of the trust that the international community has placed in an organization set up to serve the best interests of all nations.
If the IMF’s latest numbers are properly reconstructed, the Greek debt burden is much greater than portrayed—and the policy measures proposed to reduce that burden will make matters worse.
To see this, we must go back to a lesson that American economist Irving Fisher taught in 1933. He says—in italicized words—on page 344 that “the more debtors pay, the more they owe.” That pathological condition arises in the midst of Great Depressions, such as the United States in the 1930s and Greece in the last 5 years.
Here is how this principle applies today to Greece. Recall that prices in Greece have been falling for about two years now. Since debt repayment obligations do not change when businesses sell at lower prices or when wages fall, businesses and households struggle to repay their debt in that deflationary environment.
Investment and consumption are held back, the government receives less revenue, making its debt repayment harder. If fiscal austerity is imposed in such a deflationary setting, prices and wages are forced down faster, making debt repayment even harder. This is Fisher’s debt-deflation cycle. Greece is in a debt-deflation cycle. It is the medical equivalent of a trauma patient: the blood flow does not stop on its own and, in such a condition, austerity is like asking the patient to run around the block to demonstrate good faith.
The IMF’s latest numbers bear out this diagnosis. In November 2012, the IMF tentatively concluded that Greek debt was borderline sustainable if it would undertake austerity to reduce its debt burden and structural reforms to spur growth. The primary surplus (the budget surplus without interest payments) was to rise from -1½ percent in 2012 to 4½ by 2016—an extraordinary additional austerity on top of the extraordinary austerity that had already been undertaken since 2010. The Greek government actually delivered on the austerity through 2014, bringing the primary budget in balance, as per the proposed timeline.
But look what happened along the way—and this is the debt deflation cycle. In 2012, prices were expected to be broadly stable over the coming years. Instead, prices fell by over 5 percent just in 2013 and 2014.
True, it is important for Greek wages and prices to eventually fall. But because of the Irving Fisher theorem, when prices fall, the debt burden increases. To reduce the debt burden, Fisher says, not only must austerity stop, but the economy must be “reflated.” He emphasizes that it was President Franklin D. Roosevelt’s policy of reflation that ultimately stopped the Great Depression. In an analogy similar to the trauma patient, Fisher says that when tipped beyond a point, the boat continues to tilt further until it has capsized. In a deflationary economy, the bankruptcies and distress can go on in a vicious spiral for years.
This is why the further austerity, while viewed as an evident necessity by many, is counterproductive in an economic depression. The IMF’s latest research makes this clear, here and here. That research is just a gentler restatement of Fisher’s insights.
But disregarding its own research, the IMF’s debt sustainability report says that because the Greeks are incapable of delivering 4½ percent primary surplus, they should reach just up to 3½ percent. This is intended to be a concession. Economic growth, the IMF insists, will rise to 2 percent in 2016 and then to 3 percent in 2017 and 2018; importantly, prices will start rising again by between 1 and 1½ percent a year.
These forecasts are fictitious. What is the evidence? The evidence comes from Greece. The November 2012 analysis, refusing to learn the lessons from the previous two years, proved incorrect because it failed to recognize the inexorable interaction of deflation, austerity, and debt. The lesson has still not been learned.
The latest report repeats the same analysis with no explanation why the dynamics have changed. Neither is there reason to think that the global economy will provide a boost. The United States is muddling along with its weak recovery. Crucially, China is slowing down, rendering world trade anemic. It would be foolish to expect a miraculous source of external growth to lift Greece or Europe. Hence for Greece to stabilize and grow, requires maintaining a primary surplus of 0.5 percent of GDP, and that requires more debt relief than the IMF proposes.
This is why the IMF’s latest report is disingenuous. The report says that growth in Greece has failed to materialize because Greeks are incapable of undertaking sustained structural reforms. There is so much that is wrong with that statement.
First, my colleague Zsolt Darvas of Bruegel argues persuasively that the Greeks have, in fact, undertaken significant structural reform. He notes that the “Doing Business” index has improved materially and labor markets are now more flexible than in Germany.
Second, the IMF had set unrealistically high expectations of structural reforms: productivity was to jump from the lowest in the euro area to among the highest in a short period of time and labor participation rates were to jump to the German level.
Again, the IMF’s own research department cautions that the dividends from structural reforms are weak and take time to work their way through (see box 3.5 in this link).
The debt-deflation cycle works immediately. If it has taken decades for Greece to reach its low efficiency levels, it was irresponsible to assume that early reforms would turn it around in a few years. Finally, when an economy spirals down in a debt-deflation cycle, demand falls and that, in itself, will show up in the less productive use of resources. So, it is even possible that productivity has increased more but is being drowned by shrinking demand.
We may not like the conclusion, but it is quite simple. Greece has not grown and prices have fallen because that was to be expected when persistent austerity is laid on top of an unsustainable debt. The debt-deflation spiral always outpaces the returns from structural reforms. As certainly as these things can be predicted, on the path set out by the creditors, the stakes will continue to be escalated: the debt-to-GDP ratio will continue to rise, the calls for more austerity will grow, and, as the pattern repeats, more debt relief will be needed.
So we arrive at the present. The IMF looks back at its diagnosis in November 2012 and says, the Greeks did not follow our advice; it is no surprise that they are in a mess and they need more debt relief. The truth is that the Greeks are in a mess precisely because they followed the IMF’s austerity advice and because the promised elixir of structural reforms was illusory.
And the double indignity is that the IMF now wants the Greeks to do more austerity in the midst of a debt-deflation cycle because it chooses to misread the evidence of the past years. If that advice is, in fact, followed, it is nearly certain that the Greek debt burden will be greater in two years than it is now.
We may cast a moral and political spin on these facts. Indeed, it is understandable that political considerations will play a central role in the European dialogue. But the economic logic is relentless. And the IMF’s role—its only role—is to render the economic logic transparent for informed decision making. In disregard of generations of fine IMF economists and research, the IMF has engaged in its own moral posturing to retrieve its money and hide its failures.
To be clear, the argument is not that more debt relief be promised in exchange for more austerity now. The argument is that debt relief is needed now—more than the IMF suggests—to prevent the need for even more debt relief later. It is as much in the creditors’ interest to change course as it is in the Greek interest.
Once that premise is accepted, then within that basic framework there is much that the Greeks can do to improve their lot. But such is the momentum, the politics will almost surely subordinate the economic logic. That would be a mistake. At what is surely a pivotal moment in European and global history, at least the facts must be laid out transparently.
This article is republished with gratitude to the author and its original hosts who posted it to Bruegel on July 4.