Merrill Lynch Says Arguments For Inevitable Greek Default Wrong

Even as the immediate crisis in Greece fades, a number of economists are pushing the idea that an eventual Greek tragedy is either very likely or inevitable, Merrill Lynch says in a report dated March 12th.

"In recent weeks, not one, but two former chief economists of the International Monetary Fund (IMF) have argued that a bad outcome is only a matter of time. At the US Monetary Policy Forum, Ken Rogoff argued that Greece would suffer through a series of incomplete austerity plans before a likely default.

His recent blog postings are more sanguine, but clearly he sees a high probability of default. Simon Johnson is more emphatic: he refers to Greece as the “latest and greatest bubble.” Perhaps having worked at the world’s financial fire department makes you believe that smoke always means fire, but these folks sure seem negative,’’ the firm says

It adds that the inevitability argument is clearly wrong. Johnson states that a 10% interest rate on Greek debt “would be a modest premium for a country with the highest external public debt/GDP ratio in the world.” At such an interest rate, and given high foreign ownership of Greek debt, over time Greece would be sending 12% of its GDP per year abroad to service its debts. He concludes, “German reparation payments were 2.4 percent of gross national product from 1925 to 1932, and in the years immediately after 1982 the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings). Neither of these were good experiences.”

A simple simulation model confirms that under Johnson’s assumptions a Greek tragedy is inevitable.  However, Johnson and the other inevitability advocates are essentially assuming the conclusion.

“No country, no matter how high their debt, can survive chronic 10% interest rates. Thus, if Greece balances its primary budget it would still have runaway debt if interest rates were 10%. Furthermore, the reason Greek interest rates are much lower to begin with is that Greece is part of the European Union. With a guarantee from the rest of the community, its rates should converge back to the community average. Neither the Weimar Republic nor Latin America of the 1980s was part of the European Union.”

Long-run Greek tragedy depends on three things, ML says (1) the ability of the government to continue to implement austerity programs; (2) the willingness of the rest of Europe to back Greek debt; and (3) the resilience of the economy in the face of belt tightening.

In the “austerity scenario,” the firm assumes that the Greek government continues the austerity path it has started, shrinking the non-interest deficit to zero over a three-year period. And we assume with this shrinkage, Greek interest spreads drop back to their pre-crisis average. Under this scenario, the debt to GDP ratio peaks in 2011 and then slowly falls.

“It ain’t gonna be easy, but effective policy should work” it argues.