This week opens as the last one ended — with the cleavage between Greece and its creditors growing. Read the latest, here. Greek finance minister Yanis Varoufakis toured European capitals last week to discuss the Syriza government's demands for debt relief. His reception was polite, but, predictably, he wasn't embraced as the prodigal son.
The week started well with Varoufakis laying out what the Greeks undoubtedly view as constructive suggestions for the way forward. Rather than a razed earth strategy of debt write-offs, reducing the face value of the debt, he proposed a lengthening of the maturity of the debt at low interest rates. This would reduce the net present value (NPV) of the debt and provide relief in terms of debt service burden.
More interestingly, he suggested that debt be tied to growth. That is to say, the debt would provide higher payments when growth is strong; lower payments in periods of weak growth. This is a sensible approach. By making the debt more "state contingent," the government would be better able to achieve the goal of debt service without the adverse effects of fiscal austerity on employment. It should be a "win-win" proposition.
The proposal also makes explicit the point that, in a sense, sovereign debt is a conditional promise contingent on prevailing economic conditions. As the Greek government has repeatedly pointed out, it isn't the one breaking the troika economic program — the program went off track on its own, Syriza contends, as the projected growth on which it was predicated failed to materialize.
The problem is that, while growth-linked bonds are attractive in theory, there are potential practical problems with them. Most significant is the question of state verification: on whose data would the bonds be conditioned? Consider a simple example in which the bonds are conditioned on only two states — a bad state associated with low growth, and a good state when growth is high. With GDP-linked bonds, the government has a clear incentive to reveal 'bad' states when growth is poor. It is less clear that it would reveal 'good' states, since that would imply higher payments. Creditors might be forgiven for worrying that reported bad states would increase.
This is, indeed, an issue. But it is not, I think, an insurmountable challenge. Thoughtful design of the bond contracts can address this state verification problem, such that the government does not have an incentive to misrepresent the state of the world. Of course, this may require supporting side arrangements, but this shouldn't be an obstacle given that Greece is a member of the EU.
At mid-week the mood was decidedly less encouraging. The ECB announced that it would no longer accept Greek government bonds as collateral for ECB borrowings. At first blush, the ECB's action appeared as a dramatic escalation in the impasse between Athens and the euro zone authorities. But, as Paul Krugman and Wolfgang Manchu have argued, it is more likely that Mario Draghi was sending a message to Berlin. At the same time that it announced its decision on collateral, the ECB increased emergency lending limits to the Greek central bank, albeit for a limited time. In so doing, Draghi’s may have intended to remind the German authorities that there is limited time for securing a deal and that failure to reach an amicable accord could have serious consequences for the entire euro area.
If that was the intended effect, it isn't clear he succeeded. By the end of the week, German finance minister Wolfgang Schäuble and Varoufakis couldn't agree to disagree. This is not surprising, of course — indeed, the surprise would have been if the two men had agreed on anything, except perhaps the weather. Debt restructuring is a negotiation; I suspect that both sides are developing their positions. The process will take time and there will be learning on both sides.
The thing is, though, the longer that a resolution of the impasse is delayed, the greater the uncertainty that hangs over the euro zone and the global economy, writ large. In this environment, firms and households may exercise the option value of waiting, putting off investment and purchases. Needless to say, such an outcome would not be helpful in the New Age of Uncertainty.
