In bad faith – ImBookEnds

On July 2, the IMF
released its analysis of whether Greek debt was sustainable or not. The report said
that Greek debt was not sustainable and deep debt relief along with substantial
new financing were needed to stabilize Greece. In reaching this new assessment,
the IMF stated it had learned many lessons. Among them: Greeks would not take
adequate structural reforms to spur growth, they would not sell enough of their
assets to repay their debt, and they were unable to undertake sufficient fiscal
austerity.

That left no choice but
to grant Greece greater debt relief and to provide new financing to tide Greece
over till it could stand on its own feet. The relief, the IMF, says must be
provided by European creditors while the IMF is repaid in whole.

The IMF’s report is
important because it reveals that the creditors negotiated with Greece in bad
faith. For months, a haze was allowed to settle over the question of Greek debt
sustainability. The timing of the report’s release—on the eve of a historic
Greek referendum, well after the technical negotiations have broken
down—suggests that there was no intention to allow a sober analysis of the
Greek debt burden. Paul Taylor of Reuters
tells us
that the European authorities worked hard to suppress it and Landon Thomas of
the New York Times reports that,
until a few days ago, the IMF had played along.

As a result, the entire
burden of adjustment was to fall on the Greeks before any debt reduction could
even be contemplated. This conclusion was based on indefensible economic logic
and the absence of the IMF’s debt sustainability analysis intentionally biased
the negotiations.

As an international
organization responsible for global financial stability, it is the IMF’s role
to explain clearly and honestly the economic parameters of a bailout
negotiation. The Greeks, many said, benefited from low interest rates and
repayments stretched out over many years. Therefore, no debt relief was needed.
But, of course, as the IMF now makes clear, if a country has to repay about 4
percent of its income each year over the next 40 years and that country has
poor growth prospects precisely because repaying that debt will lower growth,
then debt is not sustainable. If this report had been made public earlier, the
tone of the public debate and the media’s boorish stereotyping of Greeks and its government would have been balanced
by greater clarity on the Greek position.

But the problem with
the IMF report is much more serious. Its claims to having learned lessons from
the past years are as self-serving as its call on other creditors to provide
the debt relief. The report insistently points at the Greek failings but fails
to ask if the creditors misdiagnosed the Greek patient and continued to damage
Greek economic recovery. Protected by the authority and respect that the IMF
commands, it is easy to lay the blame on the Greeks whose rebuttals are treated
as more hysterical outbursts of an (ultra) “radical” government.

The creditors’ serial errors are well documented, including by the staff of the IMF. Continuing deliberately to suppress past errors
is an act of bad faith but continuing to repeat those errors in making future
projections of the Greek debt burden is a willful abuse of the trust that the
international community has placed in an organization set up to serve the best
interests of all nations.

If the IMF’s latest
numbers are properly reconstructed, the Greek debt burden is much greater than
portrayed—and the policy measures proposed to reduce that burden will make
matters worse.

To see this, we must go
back to a lesson that American economist Irving Fisher taught in 1933. He says—in italicized words—on page 344 that “the
more debtors pay, the more they owe.” That pathological condition arises in
the midst of Great Depressions, such as the United States in the 1930s and
Greece in the last 5 years.

Here is how this
principle applies today to Greece. Recall that prices in Greece have been
falling for about two years now. Since debt repayment obligations do not change
when businesses sell at lower prices or when wages fall, businesses and
households struggle to repay their debt in that deflationary environment.

Investment and
consumption are held back, the government receives less revenue, making its
debt repayment harder. If fiscal austerity is imposed in such a deflationary
setting, prices and wages are forced down faster, making debt repayment even
harder. This is Fisher’s debt-deflation cycle. Greece is in a debt-deflation
cycle. It is the medical equivalent of a trauma patient: the blood flow does
not stop on its own and, in such a condition, austerity is like asking the
patient to run around the block to demonstrate good faith.

The IMF’s latest
numbers bear out this diagnosis. In November 2012, the IMF tentatively
concluded that Greek debt was borderline sustainable if it would undertake
austerity to reduce its debt burden and structural reforms to spur growth. The
primary surplus (the budget surplus without interest payments) was to rise from
-1½ percent in 2012 to 4½ by 2016—an extraordinary additional austerity on top
of the extraordinary austerity that had already been undertaken since 2010. The
Greek government actually delivered on the austerity through 2014, bringing the
primary budget in balance, as per the proposed timeline.

But look what happened
along the way—and this is the debt deflation cycle. In 2012, prices were
expected to be broadly stable over the coming years. Instead, prices fell by
over 5 percent just in 2013 and 2014.

True, it is important
for Greek wages and prices to eventually fall. But because of the Irving Fisher
theorem, when prices fall, the debt burden increases. To reduce the debt
burden, Fisher says, not only must austerity stop, but the economy must be
“reflated.” He emphasizes that it was President Franklin D. Roosevelt’s policy
of reflation that ultimately stopped the Great Depression. In an analogy
similar to the trauma patient, Fisher says that when tipped beyond a point, the
boat continues to tilt further until it has capsized. In a deflationary economy,
the bankruptcies and distress can go on in a vicious spiral for years.

This is why the further
austerity, while viewed as an evident necessity by many, is counterproductive
in an economic depression. The IMF’s latest research makes this clear, here and here. That research is just a gentler
restatement of Fisher’s insights.

But disregarding its
own research, the IMF’s debt sustainability report says that because the Greeks
are incapable of delivering 4½ percent primary surplus, they should reach just
up to 3½ percent. This is intended to be a concession. Economic growth, the IMF
insists, will rise to 2 percent in 2016 and then to 3 percent in 2017 and 2018;
importantly, prices will start rising again by between 1 and 1½ percent a year.

These forecasts are
fictitious. What is the evidence? The evidence comes from Greece. The November
2012 analysis, refusing to learn the lessons from the previous two years,
proved incorrect because it failed to recognize the inexorable interaction of
deflation, austerity, and debt. The lesson has still not been learned.

The latest report
repeats the same analysis with no explanation why the dynamics have changed.
Neither is there reason to think that the global economy will provide a boost.
The United States is muddling along with its weak recovery. Crucially, China is
slowing down, rendering world trade anemic. It would be foolish to expect a
miraculous source of external growth to lift Greece or Europe. Hence for Greece
to stabilize and grow, requires
maintaining a primary surplus of 0.5 percent of GDP, and that requires more
debt relief than the IMF proposes.

This is why the IMF’s
latest report is disingenuous. The report says that growth in Greece has failed
to materialize because Greeks are incapable of undertaking sustained structural
reforms. There is so much that is wrong with that statement.

First, my colleague
Zsolt Darvas of Bruegel argues persuasively that the Greeks have, in fact, undertaken significant
structural reform. He notes that the “Doing Business” index has improved
materially and labor markets are now more flexible than in Germany.

Second, the IMF had set
unrealistically high expectations of structural reforms: productivity was to
jump from the lowest in the euro area to among the highest in a short period of
time and labor participation rates were to jump to the German level.

Again, the IMF’s own
research department cautions that the dividends from structural reforms are weak and take time to work their way through (see box 3.5 in this link).

The debt-deflation
cycle works immediately. If it has taken decades for Greece to reach its low
efficiency levels, it was irresponsible to assume that early reforms would turn
it around in a few years. Finally, when an economy spirals down in a
debt-deflation cycle, demand falls and that, in itself, will show up in the
less productive use of resources. So, it is even possible that productivity has
increased more but is being drowned by shrinking demand.

We may not like the
conclusion, but it is quite simple. Greece has not grown and prices have fallen
because that was to be expected when persistent austerity is laid on top of an
unsustainable debt. The debt-deflation spiral always outpaces the returns from
structural reforms. As certainly as these things can be predicted, on the path
set out by the creditors, the stakes will continue to be escalated: the
debt-to-GDP ratio will continue to rise, the calls for more austerity will
grow, and, as the pattern repeats, more debt relief will be needed.

So we arrive at the
present. The IMF looks back at its diagnosis in November 2012 and says, the
Greeks did not follow our advice; it is no surprise that they are in a mess and
they need more debt relief. The truth is that the Greeks are in a mess
precisely because they followed the IMF’s austerity advice and because the
promised elixir of structural reforms was illusory.

And the double indignity
is that the IMF now wants the Greeks to do more austerity in the midst of a
debt-deflation cycle because it chooses to misread the evidence of the past
years. If that advice is, in fact, followed, it is nearly certain that the
Greek debt burden will be greater in two years than it is now.

We may cast a moral and
political spin on these facts. Indeed, it is understandable that political
considerations will play a central role in the European dialogue. But the
economic logic is relentless. And the IMF’s role—its only role—is to render the
economic logic transparent for informed decision making. In disregard of
generations of fine IMF economists and research, the IMF has engaged in its own moral posturing to
retrieve its money and hide its failures.

To be clear, the
argument is not that more debt relief be promised in exchange for more
austerity now. The argument is that debt relief is needed now—more than the IMF
suggests—to prevent the need for even more debt relief
later. It is as much in the creditors’ interest to change course as it is in
the Greek interest.

Once that premise is
accepted, then within that basic framework there is much that the Greeks can do
to improve their lot. But such is the momentum, the politics will almost surely
subordinate the economic logic. That would be a mistake. At what is surely a
pivotal moment in European and global history, at least the facts must be laid
out transparently.

This article is
republished with gratitude to the author and its original hosts who posted it to Bruegel
on July 4.

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