IMF Plays with Matches, Greece gets Burned

When the European phase of the debt crisis erupted, involving the IMF was controversial. However, its money, expertise, and credibility carried the day.  It became integral to the aid efforts within the monetary union.  It has reportedly signaled it does not want to participate in additional efforts to assist Greece.  

There have been several critical errors in dealing with Greece, and these errors are partly of the IMF's doing.    Many officials have expressed concern about the moral hazards that distort the incentive structure for Greece, but what of the moral hazards for the official creditors, like the IMF?

A few years ago the IMF admitted that it under-estimated the fiscal multiplier.  The austerity it demanded produced a deeper and longer lasting economic contraction (depression) than the IMF and its army of economists had expected.  This acknowledgment did not seem to prompt a change in the IMF's behavior.  

The size of the IMF's initial involvement was much larger than its own internal rules and procedures permitted.  Staff objections were reportedly over-ruled at the highest levels of the IMF. The IMF exposure to Greece in the first aid package, given the size of the Greek economy was unprecedented.  The IMF participated somewhat less in the second assistance package.  And now it signals, according to press reports, that it does not want to participate at all in a third program.  

The IMF and the EU were reluctant to allow Greece to restructure its debt for two years after the initial aid effort.  Apparently EU officials were concerned about the impact on their banks due to the exposure to Greece.  Moreover, by the time that the restructuring was approved, many non-Greek banks had reduced their exposures by selling them to the ECB.   

This made the restructuring when it did take place too small to reduce Greece's debt burden to sustainable levels.  Officials allowed the private sector to shovel their Greek exposure to the public sector and then refused to restructure that debt on grounds of protecting the taxpayers.  

It is clear that at the onset of the debt crisis, EMU lacked the institutional capability and capacity to address it.  These had to be created, and they were.   That was the key focus in those early days as it had to be.  The priority was not on fixing Greece per se, but building a firewall to protect the creditors.   

The IMF and other officials may not have broken Greece.  Years of profligate spending, dismal tax collection, an uncompetitive economy, and incentives for rent-seeking behavior did the trick. However, their attempt to fix Greece's problems exacerbated them.  Indeed, one of our key points is that the aid packages were not really about "saving" Greece, but about buying time.  No wonder Greece has not been saved. 

To the contrary, a real solution for Greece, which would have put it on a sustainable path, was sacrificed in order to protect the monetary union as a whole.  Greece has a word for this: pharmakos or scapegoat.  It is not that Greece is innocent or does not need reform.  A huge adjustment has taken place.  More is needed.  

However, not only does Greece need to be held accountable for its actions, but the official creditors do too.  The IMF has threatened not to disburse its share of the remaining tranche to Greece. It has indicated it does not want to participate in an additional aid effort.  If Greece has to choose between paying its civil servants and pensions, servicing its other creditors and servicing the IMF funds, the IMF stance underscores the incentive to delay an IMF payment.    

Last month, when Greece informally asked about postponing a payment to the IMF, it was told that developed countries have not asked for such a favor.  However, the IMF does have standard operating procedures to handle arrears.  While the IMF would deny future aid until the account was current, the threat may mean somewhat less if the IMF already indicated it would provide no further assistance.  Moreover, there is at least a month lag before the account was officials in arrears,  which means other creditors would not likely respond immediately though the markets would.  

It paid this week's obligation a day early.  However, Greece had to draw on its emergency reserves held at the IMF.  Most countries apparently have at least two accounts at the IMF.  One is where the annual quota is deposited.  The other is a holding account for emergencies.  Reports suggest it borrowed 650 mln euros from this account to pay the IMF.  It is understood that it needs to replace those funds in a few weeks.  

Eurogroup head Dijsselbloem has suggested the possibility of making some small disbursements to Greece in line with some partial agreements.  Although the details are not clear, it appears Greece has compromised on the VAT.   There are two key issues that remain, and which remain intractable regardless of the composition of the Greek negotiating team.  Pensions and wages. 

Ideas that Greece may have a referendum on whatever deal is worked out are a distraction.  Syriza won the election with a little over a third of the vote.   By getting the most popular votes, it was awarded 50 more seats in the parliament (this is in part the model for the political reforms recently adopted in Italy) and still this was not enough for a majority.   A referendum would be time consuming, and in that time, the economy would worsen and the needed reforms would not be implemented.   

Fouling in basketball, or getting a yellow/red card in European football, or a penalty in ice hockey is as much part of the game as the rules themselves. So too with EMU.  Official creditors are casting the issue as Greece should either capitulate to the demands of the official creditors or leave EMU.   This is a false dilemma.  When France unilaterally indicates it will not reach the EU-mandated budget target, no one suggests that it should have a referendum on EMU membership. There are negotiations and compromises have been repeatedly struck.    A solution needs to be found now to put Greece debt on sustainable footing within EMU.