Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 24 February 2015

Greece and primary surpluses

In my simple guide to the current macroeconomic position of Greece, I said that a major mistake made by the Troika was to insist on a pace of fiscal adjustment that was far too fast. It led to a collapse in the economy. Of course a collapse in the economy itself raises the deficit. So people who just look at the deficit, including many comments on that post, say ‘what adjustment’ and ‘just how many years does Greece need’.

It is easy to avoid this trap. The OECD publishes a series for the underlying primary balance, which is their guess at what the primary balance (taxes less spending excl. interest payments) would be if the output gap was zero. It is the first row in the table below: the estimated output gap is below. I’ve also shown the scale of the decline in GDP, just to show that the output gap numbers are pretty conservative. Unemployment in Greece is over 25%, and over half of all young people are unemployed.

Underlying primary balance
(% of GDP)
Output gap (%)
GDP growth (%)

2009 was the peak underlying primary deficit, and it was huge, representing the actions of a truly profligate government. However what followed was complete cold turkey: within two years the underlying primary balance was close to zero. A pretty conservative estimate for the impact of fiscal consolidation would reduce GDP by 1% for each 1% of GDP reduction in the primary balance. In those terms, all of the current output gap in Greece can be explained by austerity.

As I have always said, some period involving a negative output gap was inevitable because Greece had to regain the competitiveness it lost as a result of the previous boom fuelled by fiscal profligacy. But slow gradual adjustment is more efficient than cold turkey. Paul Krugman explains one reason for this: resistance to nominal wage cuts. But there is another which is even more conventional. If we have a Phillips curve where inflation expectations are endogenous (either through rational or adaptive expectations) rather than anchored to some inflation target (as Paul implicitly assumes), then competitiveness adjustment can be achieved with a much lower cost in terms of the cumulated output gap if it is done slowly. (I gave an example here, then reacting to the idea that Latvia’s cold turkey adjustment had been a success.)

There are only two serious barriers to this more efficient adjustment path. The first is the willingness of some outside body to provide the loans to fund the gradual reduction in the government’s deficit. The second is getting those outside bodies to recognise this basic macro: austerity hits output, and gradual adjustment is better. I think the second turned out to be the crucial problem with Greece: as has been extensively documented, the Troika were hopelessly optimistic about the impact cold turkey would have.

So it is as clear as it can be that the current dire position of the Greek economy is the result of a huge mistake by the Troika. The size of the collapse in the Greek economy is similar to the fall in Irish output during the Great Irish Famine of 1845-53, and while the suffering in the latter is obviously of a different order, the attitude of some in the Eurozone is as misconceived as most English politicians during the famine. Of that event they say 'God sent the blight but the English made the famine'. In the future the Greeks may justly say ‘our politicians caused the deficit but the Troika made the depression’.  


  1. Would opportunity cost for the lending party not also be important? Cold turkey leads to a shorter repayment period so the opportunity cost for the lending party will be lower: Greece pays lower interest than the return that the lending parties would get if they invested their money somewhere else.

  2. SWL, you mention the need for a bridging loan coming from someone to Greece.

    Why do you not refer to a grant of funds instead of a loan?

    This isn't private commercial gain or creditor-control time, it is time of common sense, and your blog article makes incredibly good points of a social-contract nature, in my opinion. Thanks.

    The US used general revenue sharing for quite a good time, at the time of the financial crisis recession the national government stopped the loaned-funds feature of the Unemployment counter-cyclical program, and the US has an extensive grant-in-aid system avoiding the notion of lending.

    As a signal that things are different and that we can set aside notions about being a creditor - can we not now get more people to refer first to grants, with an admixture of bridging loans (perhaps triggered by economic accomplishments).

    More loans at this time? Not sure that brightens people's eyes or quickens their steps.


  3. It would be nice to know where the intellectual foundations of cold-turkey approaches came from. Of course they were pushed during the Gold-Standard era, but more recently the orthodoxy/mainstream was firmly behind them during the Asian Financial Crisis, Collapse of the Soviet Union ("shock therapy"), Latin American debt crisis, and numerous other cases.

    1. The stagflation of the 1970's did blow some wind in the sails of certain economists (mostly those working at the Chicago business school). That's when microfoundations began to be stressed as necessary components of a good macroeconomic model. In the 1980's, real business cycle models became incredibly popular. We thought it explained a lot more about business cycle than what it actually turned out to explain upon closer inspection.

      In the 1990's, that's the sort of idea that often circulated among political (and sometimes academic) circles. It comes from an obsessive need to attribute every ills of the Earth to supply problems.

    2. Shock therapy really is grounded in a faith in markets and in business elites being politically benign. Restructure quickly--i.e. smash state levers over the economy--and you free up markets and people's natural proclivity to truck & barter. Friedman is one intellectual godfather of this tradition. Also, regarding the 1990s at least, there was this faith in the myth that East Asian dragons emerged onto the scene because of minimal states and market-driven policies (exports), when the reality was pretty important state participation (but this only became known in the late 1980s and early 1990s). In addition to this misreading of East Asian dragons, there was also a misreading of stagflation. According to one interpretation (that of Michael Piore and Charles Sabel), the problem with post-war policies is that they were incompletely Keynesianist, and the shock absorbers of stocks of cheap food/energy/labor dried up in the 1970s. (This is a structural explanation).

      Long story short, there is a mess of theory and more banal but equally important misreadings of reality. Ultimately, a lot of it seems to go back to this blind faith in "markets" automatically adjusting. But that's just one reading of all this.

    3. Something else as well. Shock therapy in Latin America and the post-socialist bloc was also grounded, albeit more subtly, in this Friedmanesque (Freedom to Choose argument) that markets and democracy go hand-in-hand. Markets and democracy are (supposedly) about choice, and state intervention in markets invariably hindered democracy, because the state would have too much power. (There is some truth to this, but the semantic trick--"markets" rather than "capitalism"--hides the truth of power relations in market economies as well.) So shock therapy would not only lead to prosperity (after nasty but quick pain) as markets (economic freedom) reasserted themselves; it would lead to political freedom. (The reality is that elites profited--whether those who made a killing with garbage privatization in Russia etc., or financial elites in Europe today.) Now, how does this matter in Europe today, with Greece? Not sure, but I wonder if there isn't a similar dynamic: the Greeks need to be freed from relying on the state or welfare, they need freedom, etc. Thinking aloud, so sorry if this seems chaotic.

    4. Thanks for your comments Stephane and Anonymous. Interesting reading.

      SM (Anon 8.39).

    5. It could just be as simple as the creditor not trusting the debtor to keep up slow reforms over multiple election cycles (the point Henry Kaspar makes below). And in addition the debtor not trusting the creditor to keep giving out new loans over multiple election cycles.

  4. Isn't it just wistful thinking to hope that a country will ever be bailed out in a non-destructive way?

    The pragmatic, take home message is instead to simply ensure that countries only ever borrow in currencies for which they have sole sovereign control. Only then will they have a "self righting ship" for which currency exchange rate shifts provide the neccessary adjustments. If a government borrows in a currency for which they don't have sole sovereign control, then a macro-economic catastrophe is basically an accident waiting to happen.

    1. Germany post-war?

    2. Life was harsh in post-war Germany (low unemployment came with low hourly wages) and they lost more sovereignty than Greece has.

    3. Germany post war did have its international debts written off but that was more debt forgiveness rather than a bailout via lending. The "financial capital" with which modern Germany was built wasn't so much foreign currency donated to Germany but rather fresh Deutsche Marks written out of thin air with a stroke of a pen. To me the Wirtschaftswunder is a testament of the extraordinary importance of sloughing off excessive financial claims as and when necessary. It shows that economic progress needs money to be used as a tool and not as a bind.
      This describes the post WWII German method:

    4. I'd add that the key thing done in Germany post WWII was to effectively write off all the debt claims that were in Reichsmarks. That provided the necessary reboot of the economy. If an attempt had been made to try and honor that debt, then perhaps wealthy people would not have lost their savings in the first instance (as they did) but more likely the debts would eventually have defaulted anyway, the Wirtschaftswunder would never have happened and there would have been endless massive unemployment and misery with even the wealthiest Germans eventually ending up poorer as a result.

    5. The 1948 transition from the Reichsmark to the Deutsche Mark is also a classic example of a "Helicopter Drop". The Deutsche Mark was introduced via a gift of 60DM to every citizen and a gift to every employer of 60DM per employee.

      All in all the 1948 Reichsmark / Deutsche Mark transition could be a good template for how Drachma-isation could be constructively handled if it comes to that. Of course Germany's success was totally dependent on other countries being willing to trade freely after the currency change and accept the write down of the Reichsmark. The problem for Greece is that the international community is not wanting to ensure a Drachma is a success. Rather they are wanting to somehow keep the euro limping on.

    6. Interesting Stone. It's great when people can tell us such history. These case studies are far more valuable than anything.

    7. There are various cases where debt relief has come with no official strings attached, in the case of Germany there were official strings. Iraq and several African countries have been granted debt relief with no official strings attached, but of course there might have been unofficial strings, which is not to say those countries didn't profit in the end. Of course all of these cases, including Germany, could point to unusual circumstances like corrupt dictatorships, colonialism and warfare, not exactly things that a population would like to repeat to get debt relief again, Greece is very different in those respects.

    8. @stone

      Could it be that you miss some improitant things:

      1) Währungsreform was 1948, whether this was creating a hard currency out of thin air is a little bit debatable, but for me a minor issue.

      2) Debt was not written down by other countries. Hint: If this were true the 1953 conference would not have been necessary. Domestic debt was written down.

      3) The aspect you conveniently ignore is, that already 1950 Germany's industry was back on track. Therfore, to claim that the rebound was possible only after write downs is again more than debatable.

      4) The write down in 1953 were, even if you do not understand the issue, mainly self-interest of France, UK and USA. Hint: the alternative would have been to rise half a million soldiers themself. So the write down of debt and a Bundeswehr as German service of return was the cheaper solution for them.

      Alternative takes on history are ok, but they should at least get the basic facts right. BTW with my "slightly" modified framework your Greek argument backfires, but I bet you know this.


    9. Anonymous@26feb, I want to understand this myself so any corrections are welcome!

      I thought that the 1953 conference was largely about the first world war debts that STILL were hanging over Germany. The Nazi era debts had already been written down in the 1940s (please correct me if I'm wrong).

      I'm sorry if I wasn't clear about recognizing that it was largely write down of domestic debts in Reichsmarks in 1948 that allowed Germany to get up and running again. I don't see why you don't view this as relevant to Greece now. Greece now is floundering because it is crushed under debt servicing costs. The same was true of Germany prior to 1948. It doesn't matter whether the debt repayments are to the IMF or to (in 1948 Germany) wealthy German creditors. All that matters is that when excessive debt servicing payments go to those who do not spend them back into the economy, then the life is sucked out of an economy.

      I also don't see how you can describe the introduction of the Deutsche Mark as being anything other than writing a new currency out of thin air. What is your alternative description of how it is done? The currency is just a medium for communicating contractual obligations isn't it? It is written out of thin air just as say battle orders are written out of thin air?

    10. I think it is an extraordinarily narrow view to imagine that Germany's Nato cooperation was what the debt forgiveness was about. The real gain of the debt write downs was to enable Germany to contribute to world prosperity by being prosperous itself. If Germany had instead been mired in permanent debt depression with mass unemployment and had been reduced to just exporting coal or whatever, then the rest of the world would not have gained all of the fantastic innovations and products that have come from the German people and would not have had the German market for our goods and services.

      It is exactly the same story with the MacArthur plan for post WWII Japan.

  5. The main barriers to slower adjustment path are different from those in the article.

    • Greece can't finance slower adjustment with more loans, it would need grants. With the current adjustment path, Greece's public debt already reaches levels that raise concern about sustainability, with many observers doubting that the 4.5 percent primary surplus needed to stabilize debt is feasible. With slower adjustment, debt would increase even more, requiring an even larger long-term primary surplus. Unless the wider deficits are financed by grants, i.e. transfers from other European taxpayers to Greek taxpayers. But as soon as one talks transfers, one doesn't talk "mainly macro" any more, but "mainly distribution".

    I would be interested in: the fiscal adjustment path that Mr. Wren-Lewis considers appropriate, the implied debt path with debt financing, and the amount of grants needed to stabilize the primary surplus at a feasible level. In other words: the full math.

    • By all historical standards, fiscal adjustment under the Greece program - stretching over 7 years (2009-16) - is slow, not fast. Adjustment is normally done in much shorter periods, as voters don't accept an endless fiscal bind. From a political economy perspective, there are pluses to swallowing the pain relatively quickly and moving on.

    The problem with Greece is the sheer magnitude of overall fiscal adjustment needed. It is so large that Greece can do the adjustment neither fast enough to make the political economy work, nor slow enough to avoid high multipliers.

    Two more observations:

    output gap and fiscal contraction. With the OECD figures (that have by far the smallest negative output gap in 2009 I’ve seen anywhere), the output gap is zero at a primary deficit of 6 percent (under the executed adjustment path). But a 6 percent primary deficit is clearly unsustainable – implying that further austerity was indispensable. In view of this, the phrase "the current output gap is explained by austerity" gives a misleading impression. Austerity and the current output gap are joint endogenous, and both the result of Greece's unsustainable fiscal position at the outset.

    endogenous inflation expectations: isn't Greece member of a currency union and has an external monetary anchor? What point is there in assuming endogenous expectations?

    Which leads to a wider point: many conventional macro-arguments that Mr. Wren-Lewis or also Paul Krugman make are conventional for the US (or the UK): an economy with quasi-unlimited fiscal space that is unconstrained in providing liquidity. But Greece operates under hard budget constraints. These relegate conventional macro often to second-order importance.

    1. 1) I talked about slower adjustment in terms of what should have happened in the past. With full initial default, that would have been perfectly feasible with loans. Right now primary surpluses mean that no new net debt is being taken on. The sooner we close the output gap, the better for all sides.
      2) The whole point of my post is that the adjustment has been over just 4 years, with too much front loaded. And its clear voters have not accepted that.
      3) The output gap was zero with a 6% deficit because the economy had become uncompetitive.
      4) I do not understand your point on expectations? A monetary union does not ensure everyone's inflation is the same - that is the key problem!
      5) Your last point is so wrong. Unfortunately there is nothing special about what is happening to most Eurozone countries - its textbook macro. The mistake is with those who call this anglo-saxon economics.

    2. Thank you for your reply. Reactions:

      1) So "full initial default" is what underlies your reasoning. This of course makes this a different story altogether (it would be worthwhile saying this upfront), and raises different issues (contagion etc.)

      [P.S. primary surpluses but overall deficits mean new debt is taken on to make interest payments]

      2) .... but the alternative is something voters are unlikely to accept either - drawn-out fiscal contraction spanning over several electoral cycles. At least I know no such example in history (while I know many cases of sharp and quick fiscal adjustment, some succesful, some not).

      3) Not sure I understand - public sector demand has to fill the gap that external demand can't fill (b/o lack of competitiveness?). If so this would beg a follow-up question - how long does it take to restore competitiveness, and is there fiscal space to fill the demand gap till then?

      4) Inflation isn't the same, but (long-term) inflation expectations should be anchored by the same external anchor

      5) The key difference to the US is lack of fiscal space, translating into a hard budget constraint that the US does not face. In the US the pace of fiscal adjustment is a choice variable. In Greece there is only a certain amount of ressources available, determined by the generosity of its financiers. The pace of fiscal adjustment is first and foremost a function of this ressource envelop. You say as much when you condition your argument on full initial default [and I sympathize with your view that the ressource envelop should be bigger]. The other key difference is that monetary policy is exogenous.

      Best regards,

    3. 1) My previous posts have said that lack of immediate and full default was one of three major mistakes made. And your PS - there should not be any interest payments while the output gap is so large.
      2) I think this is quite wrong - remember that the fiscal contraction would be more modest. Plenty of examples. The idea that Greek voters would prefer what they have had to slower adjustment is odd indeed.
      3) That is the point about needing someone to make the loans to allow gradual adjustment.
      4) Long term expectations are not relevant here.
      5) You are right that the pace of adjustment is determined by the loans, which is what I said. Of course the Eurozone periphery case is different from US/UK. But the whole point is about what loans should have been made available, if those making the loans had taken the welfare of Greece into account.

    4. Henry Kaspar, your point 5 seems to me the be all and end all of this. Basically a country should never be in the position where it faces a "hard budget constraint" as you put it. That's why the euro concept is such a disaster and it is also such a disaster when third world countries borrow in USD. I'd go so far as to say that a government borrowing in a currency other than its own is the key determinant of a country slumping into "third world" status. Europe is bringing that upon itself with the euro.

    5. Thanks (and apologies of not being fully aware of all your previous posts on the issue). Two more remarks:

      - at risk of repetition, but here and today Greece would need grants, not loans, to allow for slower adjustment (and/or less adjustment overall). Transfer of real ressources, not liquidity support. I think it's important to be clear on that.

      - not sure I understand that there "should" be no interest payments with a large output gap. Relative to what norm? Greece's public debt has a large concessional element, which brings the effective intererest rate to below Germany's. And yet annual interest cost are some 4 percent of GDP. Now the US economy would surely have near-zero rates with a similarly large output gap, but that's the global-reserve-currency-issuing US with quasi-unconstrained fiscal space. An exception rather than the rule in the global context.

    6. @ stone

      your argument extends to private sector borrwing in FX, which creates implicit public sector liabilities.

    7. Henry Kaspar, I guess the difference with private sector borrowing in FX is that those debts can (and do) more easily get written down with bankruptcies.

      You say that the USA is a special case because it is the global reserve currency but doesn't the same phenomenon extend to any government borrowing in its own sovereign currency? Japan is able to borrow as much as it wants after all. With a compliant central bank, interest rates can be kept as low as you want and deficits can be run purely at the expense of currency depreciation.
      The fact that the USA has the global reserve currency does give it the additional exorbitant privilege that it can run current account deficits without getting much depreciation BUT any country can borrow without a hard budget constraint so long as the borrowing is in that country's own currency.

    8. @ stone

      I think you are right in principle, but the picture you describe is incomplete. In a country where a government runs large deficits and uses inflation tax to finance it, demand for assets in domestic currency will fall and demand for assets in foreign currency will increase, giving domestic borrowers an incentive to contract debt in FX. In fact the very suspicion that a government might act like this can be enough, which is why FX borrowing is so widespread in economies with weak institutions.

      And private sector FX indebtedness can be enough to put a country into a bind - if the banking system's loans are mostly in FX, large depreciation will bankrupt not only borrowers but also banks, the cost of which will surely be reflected in the government's balance sheet.

    9. .... I should add that in Japan fiscal deficits have not been inflationary, as the economy has been creeping at the zero lower bound and public sector demand has just filled the gap created by weak private sector demand. This plus institutions perceived as strong have kept demand for domestic currency assets up.


    10. I think it is a chicken and egg situation where demand for domestic currency assets maintains the worth of those assets which ensures the demand. As you say, Japan does run fiscal deficts and the debts mount up and they don't get inflation. The UK also ran big deficits for 2008-2010. We had QE to "fund" those deficits and we did fine. Likewise in WWII, the UK and USA ran massive deficits and pegged bond yields to very low levels with QE-style central bank bond buying and it all worked out fine.

      The countries with disasterous sliding currencies have been those with government borrowing in foreign currency. Typically that borrowing has then simply been embezelled and sent abroad in capital flight.

      You say that the big danger is domestic borrowing in FX but that can be legislated against. In the UK my guess is that it would not be permissable to market say CHF denominated mortgages to domestic customers -the financial regulated would not permit it. Banks are quasi-governmental institutions anyway because of the level of regulation they are under. They need not be allowed to borrow in FX. Anyway I thought in the developed world banks use currency hedges to cover their borrowing in FX?

      What is the worst example of a country running fiscal deficits whilst only having government borrowing in domestic currency? All the classic examples of sliding currencies look to be the result of government borrowing in FX don't they?

    11. My view is that sliding currencies/high inflation and FX indebtedness are consequences of the same underlying institutional weaknesses. They are jointly endogenous outcomes, not one the result of the other. UK/US are countries with relatively strong institutions, so is Japan.


    12. 5) "Your last point is so wrong. Unfortunately there is nothing special about what is happening to most Eurozone countries - its textbook macro. The mistake is with those who call this anglo-saxon economics."

      Of course this is Anglo-Saxon economics. Where do you think all this 'cold turkey', 'shock therapy', 'big bang' stuff came from? Marx? Webern? Abba Lerner? This stuff came out of US economics departments and was then adopted by the IMF. Unfortunately the Greeks have not been the first to pay the price.

    13. Henry Kaspar, the euro zone in effect entails governments borrowing in FX. To my mind that is just a goofy policy blunder. I don't think that blunder was a consequence of "institutional weaknesses"; I largely blame macro economists for failing to adequately point out that blunder before the euro was enacted.

      Likewise the proposed Scottish Independence set up would have entailed government borrowing in FX -choosing that policy proposal was just a goofy blunder.

      The UK briefly dabbled in taking on USD denominated government debt in the 1970s. It predictably led to an utter fiasco with the IMF being called in. Again that was just a stupid choice. The UK didn't have any issues of institutional weakness. Before that USD debt debacle everything was fine and once it was cleared up, everything went back to being fine.

      Most of the dozens of countries that became independent in the 1950s and 1960s had BETTER potential to achieve first world levels of prosperity than Singapore had at independence. But Singapore achieved whilst most crashed into abject poverty. Singapore had no better institutions at independence than did any of those other countries. The difference IMO is that Singapore funded its government with debt issued in its own currency. I blame the government borrowing in FX by third world countries for causing them to be third world countries. I view the global three million avoidable childhood deaths we have every year as being attributable to the global system of governments borrowing in FX.

      If the IMF wasn't such a disgrace, then what they would do would be to sweep in and rescue countries by setting up systems of domestic currency funded government, writing off FX debt -NOT sweep in and saddle countries with more FX loans.

      Much of the government debt globally is drawn up under UK or US law. I think it is a disgrace that that law allows those government debt contracts to be in a currency other than the domestic currency of the government with the debt. The Jubilee Debt Campaign would do better to be a campaign to change that law. Once all global government debt was denominated in each country's own domestic currency, then government debt would stop being a problem.

    14. Very interesting Stone. It is refreshing to see people draw on history and country knowledge rather than gadgets. You look at the case of SIngapore, but I think it is difficult for many countries to issue debt in their own currencies (Indonesia, maybe many countries in South America, obviously countries politically unstable etc.) Creditors simply will not go near them. I think how many countries got around this was by having split systems (ie a domestic financial system which were segregated from trade and foreign currency finance where governments and central banks strictly controlled foreign exchange use). This is might be where we have to start getting into the nitty-gritty of institutional set-ups. Obviously the MIT macro-economists at the IMF that advised ex-Soviet Union and distressed Asian countries to open up and "modernise" their financial systems inflicted a lot of damage on the countries that obeyed them. I think Germany's view of the Greek issue is largely one about institutions, it is not about shock therapy or austerity as one where capital flows need "guidance". (In fact coming from a Social Democracy like Germany this would be very different to what the IMF historically has done.) Unfortunately though EU institutional arrangements are not set up to do this. It is caught between a rock and a hard place.

    15. One thing that surprises me though is the imposed Privatisations. This is classic IMF crisis prescription, but not something we associate with Northern Europe. I can only imagine how humiliating to Varoufakis and Syriza that must have been.

    16. @ Stone

      Again I think you have a point but your view is oversimplistic. The key is : If no one wants to hold assets in domestic currency - as no one trusts the issuer of that currency - then indebtedness in domestic currency won't happen, period. There are third world countries (and emerging economies) where everything but the most basic transactions is in FX - and the causality goes from distrust in public institutions and thus in the own currency to dollarization, not the other way round.

      Once the private sector is indebted in FX there are actually advantages of the public sector being indebted in FX too, as traded securities in domestic currency can cause large exrate fluctuations and thus large macro volatility.

      As for the euro, there are examples where currency unions work if they are small and homogenous - as the euro area is not. But even large fixed exchange rate regimes can work, see the gold standard before World War I. As long as the environment isn't too deflationary, providing economies space for nominal adjustment, and as long as moving off the exrate system remains an option. Not having any mechanisms in place for this eventuality is in my view the key architectural flaw of the euro area.

      As for the IMF, not clear to me what you think it should do. It is by construction a lender in FX, in a world with FX borrowing you need such a thing as there can be liquidity crunches in FX. It has no role in 'setting up systems of domestically funded government', only the issuer of domestic currency - the government - can do that. Now if every government would do this - which, again, pre-supposes that there is demand for domestic currency assets - and if the private sector everywhere would also contract debt in domestic currency only, there would be no FX borrowing and no need for an IMF, but that's it.

    17. Henry Kaspar, I guess I was envisioning the "New IMF" as being an institution of technocratic advisors who would help the transition to a functioning domestic currency government funding system (a bit like agricultural advisors or medical advisors etc). Currently when a new regime starts (eg the start of South Sudan as a recent new country) the banks swoop in, calculate what raw material export levels are, grant USD loans that can just be serviced by pledging all of those exports over to debt interest, and the country is set on a path to perpetual destitution. I'm envisioning an institution to get in ahead of that process.

      You say that there is no demand for local currency emerging market debt. I view that as the key fallacy. If a government deficit spends, then that new money has to go somewhere. The eventual holder of that money as savings has a choice between holding it as cash or as treasury bills/bonds. Why would a saver want to hold zero yielding cash rather than treasury bills/bonds that yield interest?

      Having the elites holding government debt denominated in local currency ensures institutional strength because the elites then have a stake in ensuring that the country prospers and taxes are collected and the currency does not slide.

      Local currency denominated emerging market debt anyway is snapped up even by developed world savers (and sovereign wealth funds etc) as a diversifying asset class. You even get ETFs of the stuff marketed to retail savers. It doesn't have default risk and so just provides exposure to emerging market currency exchange rate shifts versus our currencies - a bit like synthetic gold I guess.

    18. If a thirdworld government were to demand taxes from say major oil/ mining / banana exporting companies, payable in that third world coutry's domestic currency; then there would be demand for that currency and thus for assets denominated in it.

      Why despots like to borrow in "hard currency" is so that they can embezel the money and send it to Switzerland, and the UK etc. If they were to try that on a multibillion dollar scale with domestic currency, then before they had shipped much of it out, it would be worthless due to the depreciation that would induce. Furthermore, the wealthy bond holders would depose them.

    19. The looming opportunity to embezel and ship out borrowed hard currency means that any honest would be leader of a third world country is always going to be up against rivals who can promise henchmen a share of any prospective embezelment in exchange for help with regime change.

    20. @ stone

      As for your "fallacy": if a government spends and the recipients don't want to hold domestic currency - no matter whether in the form of cash or other financial assets - they will seek to exchange domestic currency for foreign currency. If exchanging into foreign currency is somehow outlawed - i.e the currency is non-convertible - they will seek to shed cash by buying goods, triggering inflation (and hyperinflation if the government spends at a large scale).

      Taking a less extreme case: if there is a risk premium on domestic currency assets, indebtedness in FX means that the debtor - and by extension the economy - saves real ressources. This has value, and needs to be weighed against the increased likelihood and cost of financial crises as a result of currency mismatches (and/or the cost of insuring against this by holding FX reservdes)


    21. Henry Kaspar, I agree that in a flat out hyperinflation, then basically things need to be abandoned and started afresh.

      But most of the third world is not in hyperinflation. The typical case is of a persistent long term currency slide where it takes decades to get a 100x depreciation versus USD. People are using the local currency and even holding some savings in it. If the interest rates are much like the inflation rate, then people will want government bonds. The government's transition from hard currency government debt to local currency debt will get international bond traders interested because they know that it will stem the currency slide, reduce inflation and bond yields and so make the bonds increase in value.

      Do you have any example of where a government local currency bond auction has failed? It gets touted as "what would happen" but doesn't happen in real life does it?

    22. @ stone

      as long as the central bank accepts domestic bonds as collateral it's unlikley that auctions would fail. The issue with domestic currency debt is the risk of inflation.

      Not sure why issuing domestic currency bonds would stem currency slides and reduce inflation - the temptation with doemstic currency debts is always to inflate them away. My take is that only if investors - both international and domestic - believe that this is not going to happen, domestic currency bonds will become attractive. More generally, if there would be an easy transition to DC borrowing it would already have happened.

      But over all our arguments in detail, it should not be lost that I agree with you on the basic point: FX indebtedness comes with a big risk, especially for fragile economies; if avoidable it should generally be avoided even if this comes with some costs; and joining a currency union is a way of institutionalising FX indebtedness.


    23. This comment has been removed by the author.

    24. Henry Kaspar, I'm glad you largely agree in principle.

      I'm not sure that it is sufficiently widely appreciated just how bad FX borrowing is. Isn't the creation of the euro testament to that? And the Scottish Independence idea of Scotland borrowing in GBP. I think transition to domestic currency borrowing has failed to occur enough not because it can't happen but because of ignorance and also because hard currency borrowing facilitates emezelment.

      I also fear that developed world governments have conived in the whole system because it basically enables us to get all of the scarce real natural resources in exchange for nothing more than bank statements. Oil, minerals, logs etc get shipped out of Africa etc and in return they get account statements sent to their despotic leaders -nothing real goes in the opposit direction.

      Even for something such as tea or coffee, the terms of trade are a joke. They get paid next to nothing to grow and export to us something that we can't produce ourselves here. The terms of trade are like that because the exchange rates are as they are and that comes from them needing hard currency to service their hard currency debt. We get their real output as a seigniorage profit from us writing hard currency debt.

  6. I don't think many would argue that Greece was not profligate in the past.
    By profligate I mean spending far more than was gathered in tax.
    Having been raped, the question is can they perform the new dance of mammon without admitting those old debts are unpayable?
    I think they are making the right sounds - tax evasion, and so on.
    Productivity within geographical constraint? Well, what numbers are there, and how reliable are they?

  7. Simon Why you keep deluding yourself that a good solution for Greece can/could in the past come inside the Euro?
    You propose '' immediate and full default '' in 2010.But that was impossible without Greece leaving the euro.

    1)It was politically unacceptable for other EU countries. Germany and France especially with their banks full of Greek bonds were firmly against. So any full! default would have been necessarily unilateral without agreement from EU. Which meant
    2)That ECB almost immediately in case of full default would have cut off funding for greek banks.So the greek government would either have to abandon the euro or to reverse embarrassed the default.

    So your solution was not feasible inside the euro.
    And I can’t explain various economists reluctance to say what basic macroeconomic theory suggests for Greece: Greece should exit the euro and If had done it in 2010 now it would have long recovered.
    You seem reluctant to face this simple truth and so it would be far more interesting Simon if you wrote a blog post about what would have happened in Greece if she had left Euro in 2010.
    Not fairytales about full default in 2010,gradual fiscal adjustment (which was impossible from EU creditors) and all these things with Greece staying in the euro...
    Realistic solutions not fairytales.

  8. Any thoughts on this?

  9. Simon have you read the Geithner files?

    ‘’ I said at that dinner, that meeting, you know, because the Europeans came into that meeting basically saying: “We’re going to teach the Greeks a lesson. They are really terrible. They lied to us. They suck and they were profligate and took advantage of the whole basic thing and we’re going to crush them,” was their basic attitude, all of them….’’

    So the front-loading of austerity was not a mistake it was a deliberate choice to crush the Greeks.It was a conscious attempt to punish the Greeks for their past sins.
    So Simon what Greece should have done? Stay in the euro and wait to be crushed by their ‘’partrners’’ or exit the currency?
    Also all these make the scenario of full default obviously unrealistic in the EU climate of 2010.

    1. Complete default in 2010 was perfectly feasible given the rules of the Eurozone. You are correct that it was resisted by France, Germany and others for political reasons, but it is crucially important that economists go on pointing out what the right actions should have been, rather than restricting ourselves to what might have been politically feasible at the time.

  10. There is a third barrier directly linked to the first barrier: The Greek state and its dysfunctional institutions. Why would “some outside body” (any ideas on who?) fund a gradual reduction of the deficit if the Greek state is incapable of collecting taxes? The incentive to implement even the most basic reforms would fall to zero if an outside body provided loans ad infinitum.
    So, it all reads very well but the author should recognize how unrealistic his ideas are.

    1. There is a very big space between cold turkey and providing loans ad infinitum.

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    1. It is reasonable to expect that the probability of a debtor defaulting correlates with past behavior of said debtor. It is also reasonable to expect that actions can function as precedents. You can call this a morality play, but cold hard inference would provide the exact same answers, if you're willing to look beyond the immediate future...

      If you only look at the immediate situation you might as well suggest that the global economy could easily recover by just getting rid of environmental legislation and renewable energy initiatives.

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  14. Forgive the tangent, but it's nice to see other governments learning from recent events - the conservative government in Australia has just appointed an investment banker as Treasury Secretary who is impressed by the success of austerity in the US and the UK...:

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  16. One tiny comment. Greek deflation was not 100% mathematically inevitable because Greece wasn't competitive. In purely hypothetical thoery Greek competitiveness could have been restored by inflation in Greece's trading partners. Of course there was no chance of that, so I agree with the word "inevitable" but might have added a few more words to the "because" clause. Then again, probably not worth the waste of pixels to add "given German unwillingness to accept high inflation."

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