Greece and the EU have faith that everything will work out in spite of the country's debt being a long way from sustainable. What does all that mean for the future?

If you had asked the Troika – the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF) – back in November 2010 what they thought would happen to Greece if it missed its programmed target for 2016 nominal gross domestic product (GDP) by 10%, they would have been very disappointed. They would also have recognised the problems it would cause for Greece in terms of achieving programme implementation and maintaining political support for the programme.

Greece has actually revised down 2016 projections by a mind-blowing 36%, a drop that many back in 2010 might have seen as sufficient to incite a revolution. Alexis Tsipras, Greece's hard-left leader with a soft centre, could therefore be construed as the Troika “getting away with it”. After all, it is reasonable to view the Troika as, if not actually giving birth to ruling party Syriza, then fostering its incredible rise via insistence on relentlessly unsustainable debt policies.

It is important to understand the notion of sustainability. As the IMF points out, in general terms, public debt can be regarded as sustainable when the primary balance needed to at least stabilise debt under both the baseline and realistic shock scenarios is economically and politically feasible.

This is an appropriately vague definition of sustainability; 120% of gross domestic product (GDP) – a more precise operational definition used by the Troika – is also lousy, but a useful stick the IMF has used to try to discipline the eurozone and themselves to limit the temptation to write down fantasy.

Mean or modal?

A seemingly esoteric – but for Greece critical – question is whether policy should condition on the mean or the modal outcome. The monetary policy literature has been unambiguous for more than two decades. If you condition on the mode (the single most likely outcome) then you are likely to make policy mistakes. Better to condition on mean forecasts (taking account of all plausible scenarios), because these factor in risks.

I wish the IMF would learn something from it. Take any IMF review of the Greek programme and search for the word 'risk'. It will be plastered all over the report. And the vast majority (sometimes all) will be downside.

A major contributory factor to the Troika’s disastrous forecasting performance is that policies have conditioned on the mode rather than the mean. So every time a risk materialised, the programme went further off track.

To the extent that risks were political, it made matters even more complicated. It meant that the Troika set unrealistic expectations of weak institutions, which failed to deliver, which in turn frustrated creditors and the Greeks alike. That is why we need an IMF more independent from European dominance at board and executive level. Creditors through history have typically needed to be more generous than borrowers deserve, in order to build a constituency for painful reforms in the debtor country. The IMF should be the independent body that defends that point.

Carrot and stick

Left to their own devices, creditors typically do not provide sufficient debt relief, be they Germany, Slovakia or hold-out hedge funds. It has always been understandably tempting for Germany to dangle the carrot of debt relief for good performance, but never actually give it. The dangle-and-delay policy was implemented particularly disastrously towards Antonis Samaras, the centre-right Greek prime minister. He was destroyed domestically, partly by his failure to secure debt relief internationally.

Having argued consistently for IMF reform, I was very encouraged by its recent weighty intervention by publishing draft debt sustainability analyses which were way more pessimistic than the eurozone wished to see debated in public. By 2022, debt is now projected to be at 170% of GDP, a long way above the previous sustainability metrics.

But the IMF has only learned a partial lesson. A key sentence in this analysis is: “Moreover, these projections remain subject to considerable downside risk.” So the IMF is still making the mistake of appearing to use risks as a disclaimer rather explicitly using them to form the appropriate fiscal targets.

The IMF has made big progress since its darkest days in forecasting Greece. First, from late 2011, its forecasts stopped being the stuff of fantasy; second, they have been prepared to argue publicly with the eurozone; third they have become significantly more transparent.

But it is still missing a crucial step: to condition forecasts on realistic assumptions weighted across all scenarios, rather than the IMF's own baseline in which implementation of programme assumptions is strong. It is hardly a surprise to see recent all-night policy sessions lead to flawed agreements. The dramatic unfolding of events on the night of March 15, 2013, led to Cyprus and the Troika agreeing to deposit taxes, quickly unwound the following week.

Fighting cynicism 

You can imagine leaders emerging punch-drunk in the morning and asking their technical teams how they did, and the technical teams struggling to come up with a diplomatic response, just as the leaders struggled to come up with a workable deal. But that is to be cynical. Greece may yet survive in the euro despite everything.

A more optimistic take is to acknowledge that agreement on Greece was reached, that there has been no default to the ECB, that the unbridled love of the euro is truly amazing both for a country whose GDP forecast has been revised down 36%, and for creditors asked to transfer resources to a country which has failed to implement what was asked of it.

That alone gives reason to think it might work. But risks, as they say, are skewed to the downside.

Gabriel Sterne is head of global macro research at Oxford Economics.


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