Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 19 April 2013

The Stupid Cruelty of the Creditor

In the middle ages those who could not afford to pay their debts were sent to prison by their creditors. An efficient solution to the moral hazard problem? Hardly, because the chances that the debtor could earn some money to repay something to the creditor from a prison cell were not high. So countries gradually developed rather more civilised bankruptcy laws, like Chapter 11 in the US.

Yet we are seeing the equivalent of these medieval practices in Europe at the moment. Arguably the harm being inflicted on the people of Greece by its creditors is even more cruel, and more stupid. More cruel, because the harm is being done to those totally innocent of the original contract - children indeed, as Karl Smith notes. More stupid, because those doing the damage cannot see what they are doing, either by refusing to open an economics textbook, or believing that they somehow know better.

Just look at these numbers, from the latest OECD economic outlook.

The Greek Macroeconomic Disaster

Consumption Growth %
Underlying Primary Surplus (% GDP)
Output Growth %
Unemployment %

Why is this happening? Because the Eurozone governments that foolishly bailed out Greece after the crisis first developed in 2010/11 want all their money back. (I discuss this in more detail here.)

But surely, you may say, those who lent money to the Greek government are entitled to have their money back (with interest). No one was forcing the Greek government to accept these loans, and the conditions that go with them. The creditors are justified in doing everything they can to pressure the Greeks to repay their debts, including threatening Greece with expulsion from the Eurozone. The fact that this is causing great human suffering and misery is just one of those unfortunate things, and perhaps a necessary lesson to make others think more carefully before electing governments that secretly run up unsustainable debts.

If that is what you think, then I would suggest this view is the moral equivalent of locking debtors up in prison. It is also as stupid, because the damage being done to the Greek economy and its politics is making the scale of the eventual default greater than if some debt relief was allowed now. A fiscal contraction of this scale, in a country with no independent monetary policy, was bound to do this much damage. Any macro textbook tells you that. Those who believe that reducing one component of demand just changes its mix rather than its overall level display an ignorance which in this case is close to criminal.

But, you may say, the Greek economy has become uncompetitive, and wages need to fall if the economy wants to stay part of the Eurozone. There is no escaping macroeconomic pain. True some deflation was necessary, but deflation on this scale is totally wasteful, and the immense harm it is doing is therefore avoidable. Once again, very simple macroeconomics tells you this. And, as Ryan Avent is the most recent to point out, the core of the Eurozone is making this competitiveness correction as difficult to achieve as possible. You might say that this chaos is required to achieve necessary structural reform. I seem to remember someone else once had a similar idea, which they called perpetual revolution.

Unfortunately this would not be the first time creditors have laid waste cities in an effort to recover debts, as Peter Frankopan has reminded us. But it need not be like this. Let me end by quoting Robert Kuttner, from a review of David Graeber’s book ‘Debt: the First 5000 years’.

[The Allies] wrote off 93 percent of the Nazi-era debt and postponed collection of other debts for nearly half a century. So Germany, whose debt-to-GDP ratio in 1939 was 675 percent, had a debt load of about 12 percent in the early 1950s—far less than that of the victorious Allies—helping to produce postwar Germany’s economic miracle.

The lesson from the 1920s had been learnt. Whether this was done out of self interest, because a vibrant post-war Germany benefited everyone, or compassion, I do not know. But whichever it was, the creditors of the Eurozone could use some of that wisdom right now.


  1. If a debtor acts in a way so as to induce a rational creditor to extend an unsecured loan on on the same terms as a fully collateralized risk-free loan with anything less than the intent and full expectation of the ability to repay it, then that's arguably fraud.

    However, a creditor who enters into a loan with a high credit spread to a distressed borrower is not a saver but rather an investor, a speculator and a profiteer. To claim an entitlement to repayment, is to claim a moral right to earn arbitrage profits. It's the height of self-righteous arrogance.

    And, of course, neither the citizens of the North who will lose their savings, nor the citizens of the South who will get the blame were parties to the agreements which were made entirely for the benefits of their respective corrupt politicians and bureaucrats; that being the only relevant moral of this story.

    1. Bankers benefit mostly, not politicians and bureaucrats.

  2. I completely agree with the view of this process as cruel - I saw a picture of a Greek child the other day scavenging from a garbage dump - but I keep wondering what is really motivating European leaders who I guess would claim to have pretty enlightened views of the World.

    The explanation that seems more or less rational to me is that they are very afraid of the consequences of not behaving like this. in other words Greeks, Cypriots and so on are being sacrificed in order to avoid what euro-zone leaders see as even worse consequences.

    And when I think what those could be, all I can come up with is that euro-zone leaders have concluded that the taxpayers of the core countries simply won't tolerate the cost of full debt mutualisation, and that without mutualisation and without severe macro-economic pain and internal deflation the divergences in unit labour costs between core and periphery will never be closed.

    1. " ... what is really motivating European leaders ... "

      ... is the need to prop up the bankers who lent foolishly to weak borrowers simply because they were lending Euros instead of Drachmas or Lire, etc.

      When wealthy creditors do dumb, short-sighted things, their hirelings in politics rush to make them whole. When poor debtors do dumb, short-sighted things, the politicians rush to enforce contracts and wax eloquent about the vital need to deter moral hazard. Both responses, both the pragmatic rationalizations AND the moralistic preaching, in response to the opposite sides of the very same transactions: a double standard.

    2. " the need to prop up the bankers who lent foolishly ..."

      I don't disagree with that, but the whole euro-mess is a complex network of causes and effects. Euro=zone members could not have over-borrowed or in the case of Ireland and Spain, mal-invested so badly without reckless lenders, but then the lenders would have been less reckless if interest rates had not converged so fast after 1999.

      You can argue that Governments are propping up Banks, but Governments don't see Bank failure as a preferable option, and they have to see Bank weakness as partly a consequence of the euro.

      And as usual, I am more interested in what motivates Governments than what ought to.

    3. what I cant easiliy rationalise is the fact that the creditors are periodically lending more (bail outs)in the knowledge that the situation is not improving and that further rescheduling will be required in future. Whereas at some a point a sensible view would be that a shared repayment / debt forgiveness formula that would at least avoid further bail outs or possibly even cancel the debt completely ought to prevail.
      Surely the more severe this dichotomy becomes, the more irresponsible and culpable the lender!

    4. The motivation is obvious. German banks can far better defend themselves politically from having to write down bad debts than Greek citizens can defend themselves from German-imposed austerity. European leaders are taking the path of least (domestic political) resistance.

      "... Greeks, Cypriots and so on are being sacrificed in order to avoid what euro-zone leaders see as even worse consequences."

      The "even worse consequences" are most readily understood as bad career outcomes for German politicians dumb enough to punish wealthy German investors (or even average German tax payers) to help Greek pensioners. They don't answer direct questions in this way, of course. They deflect attention to the alleged moral defects of the Greek debtors, or maybe concede that letting German banks collapse would have nasty side-effects. Nobody talks about applying the Swedish approach to restructuring the banking sector ( ). That's because the bankers hold the power and don't much like lesson number 6 (from the link): "...present owners would have to surrender control and ownership before public support was given..."

  3. And after they close the gap? Some of the countries considered "good" today will have had their competitiveness eroded as part of the adjustment process and in the next crisis find the roles reversed, now they are the "bad" countries. Will they be treated differently the next time around? No, why should we expect that? The Euro zone members are quite willing to throw over a hundred million of its members under the bus. No reason to think it will be different next time, even mighty Germany only numbers 80 million after all.

    Perhaps some "responsible" people will argue governments should do everything they can to avoid losing their country's competitive edge, but that's a pipe dream, impossible for every country to achieve. It's not necessarily desirable either, as it means depressing wages across the Eurozone. When only 1% benefit from the Euro, what then about the promises of prosperity for all with which the monetary union was sold?

    It would really help if people could see income transfers, common bank deposit guarantees and other supposedly costly policies as mutual insurance schemes. You pay today, then cash in later when it's your country in trouble.

  4. "An efficient solution to the moral hazard problem? Hardly,"

    I don't think you understand moral hazard. Prison is supposed to be a deterrent to running up debts you can't repay. I suspect it worked pretty well.

    Also, one's relations were encouraged to pay one's debts.

    1. I think you misunderstand. Hanging would have been even more effective at reducing moral hazard, but it would have produced an even more inefficient system. The problem with moral hazard is not in thinking of effective ways to reduce it, but to find ways that do not reduce overall efficiency. Not bailing out the occasional liquidity constrained bank reduces moral hazard in the banking system, but with potentially large costs.

    2. "Also, one's relations were encouraged to pay one's debts." Or, as we call it today, a codependent relationship between unreliable debtors and their more risk-averse relatives.

      There is this odd mindset that people making loans are entitled to:
      * be paid in full regardless of the debtor's ability to pay, and
      * charge higher interest rates if they choose to make risky loans due to the danger that they might not get repaid.

      The combination of high interest rates for risky loans coupled with a legal structure making it impossible to discharge debt in bankruptcy discourages responsible lending practices. Lenders believe that they have less risk if debtors lives can be destroyed at the lender's sole option (the loan shark's "broken kneecap" business model) and thus tend to make bad decisions. This punishes responsible borrowers, as lenders are motivated to loan at higher interest rates to borrowers that are less trustworthy.

      An example of this is the post-Euro lending spree to places such as Greece - lenders mistakenly believed these were low-risk loans because the loans were made in Euros, and the threat of being forced to leave the Euro was thought to impose caution. That experiment didn't work out very well, as could have been predicted from the debtor prison analogy.

      Additionally, such measures also discourage even responsible people from borrowing money. The rent versus buy decision gets complicated if a potential homeowner knows that they can be sent to prison because they were "downsized" in an economic downturn and can no longer afford their (now underwater) home.

    3. It is not reasonable to punish B for the mistakes or crimes of A, or to expect B to have been able to control A's actions. It's simplistic to blame voters for the misdeeds of their leaders, much less the citizens of tyrannies.

      The question of blame and punishment depends on who has control, who has knowledge, who has the motivation to censor or confirm, and who has the leverage to end or protect crimes in progress. Do Michelle and Stacy at the Starbucks, or Larry and Chuck the concrete professionals have the leverage to hold to account the government of the US, the Fed, the editorial team of the Wall Street Journal and the World Bank? Do they have the time to do the research? The knowledge to evaluate it?

      Well, these days the answer is probably yes. But, can their knowledge effect the actions of those agents? Thousands of informed bloggers and commenters knew for years that the US housing market was badly distorted, and even common math could prove it. (How can a sector persist when the cost of an essential steeply outstrips the incomes of its customers, with only lax lending padding the gap?) DId those thousands of informed opinions have any effect whatever on the progress of the coming disaster?

  5. It’s not much use complaining about Greek poverty: the reality is that core country voters just aren’t willing to extend more credit.

    The only constructive suggestion I have – and this is a long shot – is a short sharp burst of central economic planning in periphery countries: i.e. enforce a 20% or so wage, profit and price cut in those countries. That would get their competitive position and creditworthiness back on track.

    1. The solution is not to extend more credit, but to default on the debt. The problem is that this would do the politicians in creditor countries a lot of harm (because they made the original loans), so they have created this myth that a default would have to mean Euro exit. This was a deeply irresponsible threat to make, and I will continue to complain about it until people understand its true nature better. The whole point of this post is that it is in core country voters long term interests to allow default, but no one is putting that case to them.

    2. I think you are forgetting the Lehman lesson: the financial system is too big to fail.
      If the eurozone core would have known this, they would have realized the no bailout clause of the Lisbon treaty was a dead letter and probably never adopted the euro.
      The bailouts are in the first place to save the financial system, not just of the eurozone, but US too, and maybe the whole world.

    3. You will never get a 20% pricecut done (or any pricecut) and certainly not in dysfunctional Greece. So it would mean 20% wagescut are the only possibility (and it is against the Greek constituion if I am not mistaken and very difficult to do anyway).
      And 20% only on wages means overall maybe 10% so nowhere near enough to restore competitiveness. Prices will have to go down and substantially (and they donot until now) to restore competitiveness.
      There is simply no real solution all alternatives are (severe) damage limitation.

      Hard to see how this way we will get to A bottom. You probably need that to be able to make a new start again. Who is going to invest in a country with no growth? Nobody. Building up a reputation for social unrest of which an Arab or African country
      would be ashamed. Only way is down (for the foreseeable future).

      For those who want to go to a solution. That is not by blaming the North (voter or politician). That is by hitting them in their wallet. Aka if countries leave and go bust.
      OSI (official sector debt haircut) will happen. And the write off will become a budget item. And as a consequence to cuts and substantial ones at homes.
      How long would you think the current governments would survive when that happens? Most will not.
      How many new 'rescue' packages will be approved by ALL donor countries? The only way remaining is default.
      Not a true warrior clearly, look for the weakest spot in the enemy's defence.

      Too much believe in the human goodness as well, the whole thing will be dropped as fast as you can say souvlaki when it starts to hurt people in their own pocket. The Greek become directly lazy beachbums (if they are not already adressed that way now), and pensioned right from kindergarten. You donot wake Northeners (or anybody else) up with stories of poor Greeks, this is not Charles Dickens. Not if the alternative is cuts in their own entitlements. They wake up when they face cuts themselves.

    4. A 20% reduction in wages and profits - how do you do that, by the way? - means a 20+% reduction in tax revenue. In what way is that supposed to help?

      And central planning? Anyone seen the USSR recently?

    5. Prof Wren-Lewis,

      don't forget that the bailouts to Greece was actually a disguised bailout of the German and French banks and insurance companies that were exposed to Greece.

      That spared the politicians in those countries the embarrassment of having to explain to their voters why the public purse must bail out their banks. It was not by any real measure, meant for the benefit of Greeks.


  6. One of the biggest problem of the modern Capitalism is the lack of an upright relationship between creditors and debtors, and the consequent lack of any responsabilities from both two parts. As debtors should maintain their ethical promise to pay back money received,creditors have to make payable the debt, and to be sure about the possiblity that debtors will be able to pay - a sort of due diligence. If Greece has no liquidity, as a lot of others countries in this moment, making pressures on banks and citizens is not the solution to the problem, but the origin of future and worst problems. Restructuring the debt instead of asking more sacrifices could be the good way to follow and, generally, for the birth of a new concept of Finance, based on the purpose to let Economy, real Economy, grow, and nothing else.

  7. Greece and Cyprus risk becoming failed states. Their governments don't seem to have the competence to deal with such a crisis. Fiscal stimulus or austerity wouldn't have made much difference, as the end result in both cases would be the same: a bigger, unsustainable debt hole.

  8. Ah, the moral purity of the creditor. Does the creditor not think that seeking the perpetual enslavement of the debtor is morally reprehensible, and more reprehensible, than the debtor acquiring the debt in the first place? Or does he deny that a possibility?

    The case of Greece is worse: Its elite siphoned off the money for their own use, and left the people holding the debt, and the burden of having to pay it back. See: "Yanis Varoufakis: Greek Banksters in Action – On the Latest Twist in the Story of Mafia-Style Terror Spreading Through the Greek Polity," at his blog.

    Thus the innocent are enslaved, to settle the demands of foreign creditors. The creditors’ actions are worse than stupid. They are evil. Especially since they likely know those they are shaking down for repayment are not the ones who got the money.

  9. To what extent was the purported bailout of Greece a disguised bailout of banks of France, Germany, and other countries? From what I have heard, only around 20% of the bailout actually stayed in the Greek economy. There are and were those who regarded the Greek bailout as a sham, one that was meant to fail.

  10. The effect of this on everyday life in Athens

  11. This comment has been removed by a blog administrator.

  12. They want their money back as otherwise their own head is on the block.
    The rescue uptil now has been 'financed' by guarantees, aka Off BS financing. Or via the ECB that also wants its money back. Otherwise would need a recap which has to come from the local CB who often have to ask their government themselves. Same problem but with some steps in between.

    Except and for the whole EZ the total rescue has only for a few Bn gone over the 17 countries budgets. Off course in economic terms losses have been made, but as far as public finance goes nada, just a few Bn Euros.
    Even profits have been made via the ECB. The ECB buying bonds substantially below nominal and moving the BS value to nominal.
    And the 'profits' via the CBs distributed to the governments in several cases. The Dutch closed so a whole in their budget a few months ago. Germany's politicians were disappointed as dividends from the Buba received were lower than usual (due to a provision for the same stuff).

    Anyway OSI means a real haircut which means a real budget expense, which means less money to spend on other things, which means real cuts for almost everyone as they are already over the 3% hurdle. Which means voters for the first time will really feel the financial burden of the rescues.
    That is whem imho the party will get really started. Say for a Greek cut Germany has to find 30 Bn and Holland 7 Bn, Austria 4, Finland 2.. Real money we are talking about.

    Donot expect it if anyway possible to happen before the German elections.

    Anyway it is beyond moronic to have a 200 Bn problem and after 250 Bn packages there is still a problem in the 250 Bn (with everything as positively seen as possible) left. In my world there is a 300 Bn gap.

    Research shows that austerity fatigue hits in after say 2 years after the main consequences we are there. And 40% of the Greeks want to leave the Euro (and rising).

    It is btw no myth that default will mean an exit. Basically according to the rules the ECB will have to pull the plug, which means if Greeks want its banking sector to survive it has to go independent.
    Which means it has to leave the EU as well. So are the rules of the game. And unless the treaty is changed beforehand it will be difficult to do otherwise.
    Maybe a solution can be found. But at the moment all roads look blocked. Rules are so important as there are huge conflicts of interest and differences of opinion and unlikely the rules can be changed. Eg Cameron wants a reneg and he needs to approve the treaty change like all 27, why would he agree if there is nothing in for him?

    Summarised a bit of a mess.

  13. I think that Dr Prof Wren should state, for the record, where he stood on sanctions agaisnt' Saddam Hussien's Iraq, Castro's Cuba, etc etc
    Did he think that sanctions hurting the children of Iraq were a good idea ?

  14. I suspect the textbooks embody the prescriptions that created this mess.

  15. "True some deflation was necessary, but deflation on this scale is totally wasteful"

    By your calcuation how much was necessary and how do you know that?

  16. Regarding those starving children, one should also point at the responsibility of the Greek government and society. Yes, European policies create massive unemployment, but it is the Greek government that decides to have unemployment and welfare benefits that are extremely low. Greek unemployed without children do not receive any benefits after between one and two years of unemployment. Greek unemployed with children get only a pitiful amount. These are not measures that were demanded by the creditors of Greece, they were already in place before the crisis started. Naturally, the depression now exposes the huge cost of such an underdeveloped social safety net.
    I live in Estonia, which has a significantly lower per capita GDP than Greece, and our economy also shrank with 20% in 2008-2009, unemployment was 20% at it´s highest (and would have been higher if not for massive migration) and the government engaged in significant fiscal tightening. But children did and do not ´starve´ here (there are always exceptions). Benefits are low but not so low that the unemployed cannot feed their children. Now, if a poor society like Estonia can have such a safety net, then why can´t Greece? The Greek economy has taken a big hit but still has a per capita GDP higher then countries like Poland, Latvia, Estonia and Hungary. To me, Greece seems a society were compassion for poor people seems largely absent, with attitudes that one would rather expect in certain Latin American countries. (check benefits for long term unemployed)

  17. Since I was the person who first mentioned Greek children, maybe I should answer your comment here. To me, the point is not that the Depression in Greece exposed an underdeveloped social safety net. It certainly did that, but the depression wasn't necessary in the first place.

    People are still talking as if austerity in the euro-zone was something that was needed. Like you, they point to Estonia as a country that successfully survived austerity.

    But what was the point? What did Estonia get out of a 20% contraction of GDP and 20% unemployment? What did this experience achieve? In concrete terms it resulted in a lot of lost production and a lot of workers sitting idle.

    The alternative - for example, defaulting on debt, leaving the euro and devaluing - would have been embarrassing and would have resulted in large losses for Banks, but the human cost would have been much less.

    In the UK we complain about our "austerity" that isn't, but few of us can even conceive of what 20-25% unemployment does to a society. Our depression folk memories are of 15% unemployment, and we think of even that as a preventable disaster.

  18. Dear Jon,

    I would certainly not claim that Estonia successfully survived austerity. I think the amount of austerity Estonia imposed was unnecessary and created way too much unemployment and suffering.

    I also don´t agree with the austerity that is now imposed in the euro zone.

    But, and this is my only point, despite this in Estonia we did not have the same problem with ´starving children´, because our safety net was and is much better compared with the Greek one.
    I remain convinced that Greece with some political will, even in current circumstances, could prevent this particular issue.

  19. @jon
    Research shows that no investments of any kind take place (hardly better) approx 2 years (a magic period for thes kind of things) after the state goes bust. I think the research is from the Dutch CB/DNB in English btw approx 2 years ago on their website.
    You basically always have a contraction.

    On Estonia they have swallowed the turd but are one of the few that started again. Creating a platform (economic one mainly) (basically swallowing the turd) and quickly to be able to have a fresh start seems to work. Looking back Greece now has in total suffered much more and much longer. And Spain and Co look to be going in the same direction. They simply keep chewing on it but never take it on the chin.

    On poverty. Greece as a percentage of GDP spends more on its state including welfare than Germany. It has roughly twice the number of civil servants per capita than Holland with a properly (well for a government) functioning government. With Germany it is much worse but that is not really a fair comparison.
    Greece is still among the 20% richest per capita GDP countries. Greece tax revenue (even after deduction of interest paid) is still as a percentage of GDP equal to that of many Northern countries.

    In other words Greece's government is simply dysfunctional. Inefficient is not the right word, it is much worse than that. It cannot properly organise a society with the funds it has for that, while these funds look clearly sufficient to have some sort of a social safety net. Not that Greeks donot want that they simply donot want to pay for it. Or better rather use the funds to keep unions quiet and not fire useless workers or have a desk job for their cousin.
    It is simply a complete mess of a government.

    So next to its debt problem and its uncompetitiveness (Greek workers are not in any way a bargain for a place that far away from markets and the skill and educationlevel (including languageskills read: mainly English) they have. I rather employ a Chinese or a properly educated Indian everyday. Next to the high price level in general for a country with that much economic potential. The third problem is they have a dysfunctional government system. This is a government that charges 45% of GDP roughly for a welfarestate that isnot and other government tasks can be done for around 15% and pretty decent (in another universe to Greece). So basically they charge their people 45% and give them a lot of red tape to deal with on top of that for which an efficient costprice might be 10%. In a market that is getting overcrowded by lot of cheap Asians.

    Solving the debt problem as Simon suggests makes things a bit easier, but they will still have to make a much deeper dive if they want to start to be competitive again.
    If Greece want to get back where it was (without overborrowing and EU subsidies) it will have to change considerably cut its civil servants with 50% and make the rest 150% more efficient, cut red tape, probably cut taxes as well. Increase education. But instead they keep voting for the same corrupt incompetent morons. Some people can not be saved and you are right on that one poor children suffer.

  20. But haven't you heard about the Merkel Moratorium?


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