Four fundamental flaws have compromised Greek policy efforts and need to be reconsidered for the country to emerge from the financial crisis.

While the European crisis seemingly began as an event isolated to Greece, in less than two years it has extended in one way or another to most European countries. Just one month ago, renewed assurances that Europe was finally containing Greece’s impact were met with new credit and funding pressures throughout the continent. Financial markets are thus unsettled by the prospect of yet another Greek financial programme failure that signals that there is no real funding commitment to preserve the euro.

The failure of the Greek programmes has been seen by many as a Greek failure. Until now, few have considered the possibility that it could be a fault with the programmes themselves. Yet, these failures are so stark that in the Greek election on June 17, 2012, none of the candidates proposed keeping the existing programmes in their entirety. Instead, their focus was on bringing about the necessary changes that could help Greece finally resolve its crisis.

Solvency crisis

The Greek programmes pursued until now have all failed because they are based on fairly isolated and dogmatic views of the world that is abstract from how financial markets actually work. Instead they rely solely on cash-flow fiscal adjustments to restore creditworthiness. In the current strategy, cash flows are all that matter and stocks of debt are irrelevant. Crises are thus resolved by providing liquidity, rather than by forcefully addressing solvency in an orderly manner.

Unfortunately, the European financial crisis is a solvency crisis, not just a liquidity crisis. Without ensuring that debt stocks and banks’ balance sheets become sustainable today, the crisis will continue to worsen at a pace, as no one wants to take the pending losses.

At the crux of the failure is the limited experience that Europe has in responding to severe financial crises. The Greek economic and financial programmes have repeatedly failed because they have tried to make debt stocks sustainable – or stable as a share of the economy – after many years instead of today, which is what investors need. By not ensuring solvency and sustainability today, four fundamental flaws have compromised past policy efforts and thus need to be reconsidered to give Greece a chance to succeed.

First, by not making the sovereign Greek debt sustainable from the beginning, past programmes have failed to fully assign all the losses or write-offs that would ensure that the remaining debt be supported immediately by the Greek economy without needing outside assistance. In assessing debt write-offs, all we need to recognise is that write-offs are a consequence of irresponsible past fiscal actions and not the dramatic present bravado of failed honour as many mistakenly see it. The debt burden became unsustainable, and the past cannot be changed.

By not fully assigning all the losses, or assessing the full write-offs, the capital inflows and any private investment that could have strengthened growth was limited. Capital inflows and domestic credit would have filled the vacuum created by the fiscal adjustment that is needed to signal commitment. Not surprisingly, the fiscal adjustment in isolation only exacerbated the economic contraction.

Bad choices

The second flaw was that the financial support invariably needed to resolve a financial crisis was granted before instead of after all the losses were assigned and the debt was restructured. By doing this, the official debt became part of the problem. As such, the private debt restructuring that Greece pursued recently resulted in a private write-off of about 74%, but only of about one-third of all private and official debt.

While a 74% write-off would have been sufficient to restore sustainability two years ago, it is not sufficient now that Greece is a much smaller economy with a lot more official debt. This means that Greece now needs either official debt write-offs, or a large amount of front-loaded official financing.

Third, by not providing front-loaded financing, but rather pursuing a drop-by-drop approach, Greece has not had a fair chance of pursuing a successful crisis resolution strategy. Front-loaded financing would give Greece the time needed to signal credibly that its debt repayments are no longer compromised. The key is that whatever financing is granted, it needs to be front-loaded.

Fourth, Greece needs a new crisis resolution strategy and financial programme that is European in reach and Greek in origin. Within it, Greece’s past failure in reaching its fiscal targets needs to be seen for what it is: a failure to set realistic targets that are also based on a broad range of critical goals, including domestic credit goals that support Greek growth.

To succeed, Greece needs to be supported through a sound strategy. This is the choice that Greece appeared to make on June 17, but it is also the choice European leaders need to make soon.

Guillermo Nielsen was secretary of finance in charge of Argentina's 2005 debt restructuring and former Argentine ambassador to Germany. José M Barrionuevo led a team at Barclays that advised on the restructuring. E Manos Hatzakis is a financial consultant to the Greek government. Nikolaos Georgikopoulos is a research fellow at the Greek Centre of Planning and Economic Research.


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