BRUSSELS – The first de facto default of a country classified as “developed” has now taken place, with private international creditors “voluntarily” accepting a “haircut” of more than 50 percent on their claims on the Greek government. As a result, Greece now owes very little to private foreign creditors.
Greece also agreed to even more stringent budget targets and, in return, received financial support of more than €100 billion ($134 billion). The purpose of the entire package is to avoid a full-scale default and allow the country to complete its financial adjustments without overly unsettling financial markets. But this approach (a haircut on private-sector debt plus fiscal adjustment) is unlikely to work on its own.
The real problem in Greece is no longer the fiscal deficit, but a combination of deposit flight and continuing excessive consumption in the private sector, which for more than a decade now has been accustomed to spending much more than it earns. This over-consumption had been financed (at least until now) by the government, and, as a consequence, most of the foreign debt comprised public-sector liabilities. The official line is that Greek over-consumption will cease once the government reins in expenditure and increases taxes.
But this might not turn out to be the case. The Greek population has become accustomed to consuming above its means; and it can continue to do so because it effectively faces what the Hungarian economist János Kornai, analyzing the failings of socialism, called “a soft budget constraint.” When Greek households have to pay higher taxes, they can simply withdraw the funds from their savings accounts and continue spending much as before. That is why, despite the strong fiscal adjustment, Greece's current-account deficit remains close to 10 percent of GDP.
Moreover, depositors have increasingly withdrawn their funds from Greek banks and transferred the money abroad. Estimates vary, but the best guess seems to be €50 billion, which is equivalent to a whopping 25 percent of GDP.
This cannot go on. Greece cannot regain access to financial markets until the current-account deficit is eliminated and deposit flight stops.
Unfortunately, the opportunity cost of keeping a bank deposit in Greece is rather low. Greek banks currently pay their depositors only about 2.8 percent interest. While this is better than zero at a German bank, the difference is too small to make a difference, given the real danger that Greece might have to leave the eurozone, which would render local deposits worthless.
So interest rates must thus be substantially increased to induce Greek savers to keep their deposits and thus stop the hemorrhage from the Greek banking system. At the same time, the cost of financing excessive expenditure must also be increased; otherwise, the current-account deficit will persist.
The cost of credit for the Greek private sector remains surprisingly low for an economy that has been totally cut off from foreign capital markets, and whose government cannot obtain private funds under any terms. The average cost of new loans to Greek enterprises and households is still only 6-7 percent. This might appear substantial, but it is only a few percentage points higher than in Germany.
This must change. Estonia, which had an even larger current-account deficit before the crisis, provides an interesting counterexample. There, borrowing costs for new loans shot higher than 40 percent when the financial crisis erupted. This led to a very sharp adjustment in domestic consumption. But this brutal adjustment quickly turned the current-account balance into a surplus, and the country's creditworthiness was never questioned.
But why are interest rates in Greece still so low? The answer is simple: Greek banks still have access to financing from the European Central Bank at very low rates (1-3 percent). As long as this flow of cheap money continues, so will capital flight; no adjustment in consumption will take place so long as the country faces only a very soft budget constraint.
This is also the reason why the existing adjustment program would not be sufficient even if the Greek government were to implement everything as planned. If nothing is done to stop the capital flight and reduce private domestic expenditure, the Greek banking system will become ever more dependent on “monetary” financing. But the ECB has already provided about €120 billion (60 percent of Greek GDP) to Greece's banks, and cannot tolerate any further increase in its exposure to a country that has just defaulted.
Massive increases in domestic interest rates might still be sufficient to induce savers to keep their deposits at home. If this is not done quickly, deposit flight is likely to escalate, and the government will in the end have to impose a freeze on deposits or capital controls. But any move of this kind would lead to a breakdown of the Greek banking system and, potentially, to massive contagion affecting Portugal, Spain, and Italy.
If Europe's policymakers do not recognize that deposit flight and continuing excessive private expenditure constitute the real danger to the adjustment program in Greece, they might soon have to deal with another crisis – hard to imagine today – of even bigger proportions.
Daniel Gros is Director of the Center for European Policy Studies. Copyright: Project Syndicate, 2012.