Let’s talk about Greece

Interfluidity has an excellent post on Greece and I don’t wish to repeat what he’s written much more fluently than I could. But I want to use something he said as a segue into a deeper conversation about how we should think about Greece (and sovereign default in general):

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

There’s no getting around the fact that Greece needs debt relief. The IMF has made this clear in no uncertain terms. If the fundamental purpose of finance is to align asymmetric incentives in an efficient way, creating an environment of trust, and hence lending and development, the Greek dilemma is more than a failure of European integration. It’s a failure of finance itself.

Where Steve Randy Waldman channels his fury at the political failure of European authorities, Michael Pettis has an extraordinarily prescient essay – from February! – begging Europeans to pay attention to financial distress and poorly aligned incentives. You have two ways of doing this. You can either tell Greece that you won’t roll over its debt unless it engages in a series of politically unpalatable policies to secure your principal or you can recognize that success is shared and create a debt structure that reflects this mutual enterprise.

Quite simply, the Greek government should sell optionality on its prosperity. As much as countries are not corporations one of the purposes of Chapter 11 is to ensure that senior creditors do not force an inefficient liquidation on the entire corporate structure. For example, selling assets to meet financing requirements even if the company has a really good ten-year plan. Or, for example, forcing a degree of austerity that would wreck domestic agency to make your initial investments whole.

And whatever you think about fiscal policy, that’s exactly what this is. Whether you like Syriza or not, that is the democratically-elected government of Greece and hence its representative. And, therefore, by proposing a restructuring scheme that forces the other party into capital controls that asphyxiate domestic business you are partaking in precisely the form of liquidation that Chapter 11 seeks to avoid.

At least in the case of a distressed shipping company – or whatever – it’s possible to see why someone would want this. The number of senior creditors are small, the upside is capped, and the benefits to immediate liquidation are obvious. In the case of forcing Greece to make whole its current capital commitments the benefits are distributed across millions of European tax payers, the costs are concentrated among the Greeks, and that’s not even considering the spillovers of financial distress and turmoil generated by the plan.

And don’t kid yourself that the referendum changes things. A “no” vote only exacerbates the above and the “yes” vote seems to be the precise definition of “kicking the can”. As I’ve written before, if you eventually default (and Greece will, in some fashion or form, default) it will always have been better to default one day before after the fact.

Senior creditors are, when they cannot be made whole, given the option to buy equity (at what would be a discounted price relative to normal liquidity conditions). Some will sell these and write-off their losses, furnishing a lucrative industry in special situations investing. Regardless, creditors painfully recognize their losses, and move to align their incentives with the firm, gaining optionality in the process.

One obvious way to do this is to exchange a meaningful portion of the principal for GDP-indexed bonds. These have been discussed in detail elsewhere. It’s not clear that these are a bad idea, but it’s certainly not clear they’re a good idea, either – or the quickest and most obvious way to align European incentives. Argentina sold GDP-warrents in 2002 and investors were recognizing dramatic losses years after the fact (that’s not necessarily an indictment of the idea as much as that they are a straightforward salve). Not to mention Greece actually offered something like a GDP-bond in 2012 without any of the benefits proponents advocated (again, this might be an issue of magnitude but that’s not really the question).

Rather, Greece can sell calls on its export revenue. For one, this isn’t subject to the same measurement complexities that plague GDP (and when we’re talking billions of dollars in coupon payments, this matters). More importantly, exports are a much quicker and sensitive guide to adjustment performance than GDP, which can years to reflect structural improvements. Now the obvious flaw of export calls by themselves is that it’s not clear that the Greece government really cares about higher exports (even if its population does).

Here we can incorporate German sensibilities. Exports that fall below some benchmark on which the option is indexed incur a penalty in proportion to outstanding debt that would come out of a pool of “optional austerity” consisting of pensions, national assets, and defense spending. This would ensure that authorities engage in the sort of reforms – removing red tape, reallocating taxes, subsidizing the right things, and encouraging devaluation over unemployment – in a way that austerity resulting from failure would be predictable.

The final part is important. The IMF wants to give Greece a 20-year grace period before requiring any debt payments. What if we cut that in half, and indexed the coupon payments by an reverse exponential weighted average of net export performance over the next 10 years. This would allow Greece the freedom to implement policy that is responsible but not too responsible.

Maybe austerity is necessary and maybe it’s not. We can recognize the corruption of the Greek government without making a claim on how much austerity it needs. Michael Pettis has the key point:

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.

And we shouldn’t expect Greece be any different. Without growth any Greek repayment schedule is doomed. Economically yes, but politically certainly. By opening a market determined pool of austerity as Greece misses its export (or other benchmark) targets, and offering the upside on any growth above that benchmark over the next 10 years, authorities will be forced to focus on a long-term economic salve. And, in this world, we let Greece grow and pay back what it can first, if that doesn’t work take a cut from its optional austerity pool, and if that doesn’t work let it default once and for all. And that’s basically what Eurocrats should have done decades ago.

Addendum: Tyler Cowen doesn’t agree with the Steve Randy Waldman post on what I think is weak reasoning. Germany is trying to maximize its return as senior creditor. In a Chapter 11 (not that this is the same, but follow the logic), the court’s responsibility is to maximize stakeholder value. To the extent this is more than a plain wealth transfer – that it will further depress demand in a region already rife with unemployment and poverty – further austerity does not meet the criterion. Sure, the German government has a responsibility to its taxpayers, but the per capita cost of a “stakeholder maximizing” agreement, I suspect, is not meaningfully important. (Yes, folks, the ECB’s monetary policy very likely had fiscal risks).

For Germans maybe it’s about setting precedent. For one, it really isn’t clear that Greek is strategically defaulting because it doesn’t feel like it (the austerity it has endured remains testament to its commitment to a European project). As IMF reports I’ve linked to before suggest, in most cases default isn’t costly precisely because markets don’t believe it sets some sort of precedent of irresponsibility.

Regardless, to the extent setting precedent is about the continuity of the European project, one can’t seriously argue that recent brinkmanship (on either side) has served greater service to further unity. Germany should allow this because there seems to be near-unanimous consensus that its preferred policy landscape is not maximizing the value of the European enterprise.

(On the criticism of American economists, he is right. Capital controls are a form of austerity – granted maybe an ideal form of austerity – requiring much short-term pain for potential long-term payoffs. It is easy to sit at Princeton and suggest that this is a good idea, when trade credit dries up and importers cannot purchase energy to turn on the lights it is quite a different matter).