WSJ: Greece Deserves Credit, but Debt’s an Issue

The debate raging over Greece’s place in the euro zone has obscured an important fact: Many of the most painful steps of the Greek bailout have already been completed.

That has implications for how euro-zone authorities respond to the antibailout backlash in Greece. Why, after two arduous years of negotiations, austerity and halting progress, would the euro zone risk the chaos created by a Greek exit if the government doesn’t follow the bailout program as promised?

Consider what has been accomplished. Greece has cut its budget deficit sharply; its budget deficit excluding interest payments isn’t far from balance. Euro-zone politicians, defying domestic opposition, have put together two enormous bailouts for the government and engineered an ambitious restructuring of its debt, all to keep Greece from dropping the euro.

The toughest question left is Greece’s remaining debt, which will increasingly be held by euro-zone governments. The line from European officialdom is that Greece must repay this debt as foreseen by the bailout program. After all, Greece and its private-sector creditors just spent months negotiating a debt exchange that more than halved the value of their Greek bonds. That wasn’t enough?

Markets don’t think so. Greek 10-year bond yields were 18% right after the exchange in March. Yields like that imply a significant risk of default.

It isn’t hard to see why. The bailout envisions Greece with debt at 120% of gross domestic product in 2020, still very high. And many economists believe the assumptions made by the “troika” of the European Commission, International Monetary Fund and the European Central Bank in the second bailout—for example, that the Greek economy would contract only 4.7% this year—are too optimistic.

“Take the troika’s forecasts of Greek GDP with a hefty pinch of salt, because the economy is in free fall,” said Simon Tilford, an economist at the Centre for European Reform in London. Greek GDP fell 6.2% in the first quarter, the Greek statistics agency said this week.

If growth continues to underperform expectations, Greece’s debt won’t be much lower in 2020 than it is today.

“There will be have to be haircuts on the loans made to Greece by the euro-zone governments,” Mr. Tilford said.

Another cut to the interest rate on these loans, valued at about €52.9 billion ($67.3 billion), could be the first step, said one euro-zone official involved in the discussions.

Most analysts and investors agree Greece’s remaining debt won’t be repaid in full, whether it stays in the currency area or leaves it.

But wouldn’t forgiving more of Greece’s debt be a reward for bad behavior? It depends how you look at it. Greece has missed plenty of budget targets, but over the past two years, the government has cut its primary deficit—the budget deficit excluding interest payments—to 2.2% of GDP in 2011 from 10.6% in 2009.

That is a huge amount of austerity undertaken amid economic headwinds that make deficit cutting particularly hard. Greece’s primary deficit is now smaller than those of several other countries in the euro zone, including France, the Netherlands, Spain and Luxembourg.

Greece now needs its creditors much less to pay pensions, civil-servant salaries and otherwise fund the operations of the government. Most lending from the euro zone and the IMF is now going to pay interest on existing debt, which will increasingly be owned by the euro zone itself, rather than fund the government’s operating expenses.

More cuts and overhauls are needed, particularly to improve Greek competitiveness, but that is a significant accomplishment, given how dysfunctional Greece’s budgeting was when the bailout began. More debt forgiveness could be the euro zone’s reward to Greece for a tough job, more-or-less well done.

But if the euro zone insists that Greece follow the bailout, the government’s relatively small primary balance makes life outside the euro zone more feasible. Greece would default on its debt and adopt its own currency with its government spending and revenue roughly in line.

While that would be a painful step for Greece, it might be even worse for the rest of the euro zone.

“The contagion then to the rest of the euro zone would be very grave,” Mr. Tilford said. “It’s clear from what we’ve seen in Spain and asset prices across the south over the past week that the contagion risk is very clear.”

Bailouts for Spain and Italy might be required, dwarfing the cost of keeping Greece in the euro-zone fold and possibly fracturing the currency area. That should make the game of chicken euro-zone politicians are playing with the recession-weary Greek public look much less appealing.

Write to Matthew Dalton at [email protected]