Death by Debt - My Response to The German Finance Ministry

5 august 2015

Jeffrey Sachs is an American economist and director of the Earth Institute at Columbia University.

Resume: Dr. Ludger Schuknecht explains his ministry’s viewpoint regarding Greece. This viewpoint essentially holds that Eurozone countries should live within their means and adjust to their debt burdens.

Dr. Ludger Schuknecht, senior economist at the Germany Finance Ministry, explains his ministry’s viewpoint regarding Greece. This viewpoint essentially holds that Eurozone countries should live within their means; adjust to their debt burdens; and take their reform medicine as needed. If they do so, they will be successful, as illustrated by Ireland, Spain, and Portugal. Greece has only itself to blame, and indeed was on track to recover as of late 2014 if it had not deviated from its course.  

I have enormous respect for Dr. Schuknecht as an able and thoughtful economist. Yet I believe that he misses a historical reality. While his policy prescription is certainly correct most of the time – countries should repay their debts and take the reform actions necessary to do so – it is also sometimes wrong.  It is wrong when debt servicing, combined with other economic ills, can push society to the breaking point.  The wisdom is to recognize the times that it is wrong and to act creatively at those times.

It was wrong in the case of Weimar Germany in the 1920s and early 1930s, when Germany was pushed into hyperinflation and then depression. Germans pleaded to the US for long-term financial relief from reparations and debt payments, but didn’t get it in time.  First came the hyperinflation; then mass unemployment; then a banking collapse; and then a full run on the German banking system in 1931, leading to a closure of the banks (as in Greece today).  President Herbert Hoover eventually granted a debt moratorium but too late: Hitler came to power in January 1933.  

It was wrong in the case of many Latin American countries in the 1980s.  During the 1970s, unwise US bank lending and unwise borrowing by Latin governments led to the calamitous Latin American debt crisis of the 1980s following the sharp rise in US interest rates in 1981.  For several years in the 1980s, the US insisted on a policy of “extend-and-pretend,” that is, to lend the debtor country the money needed to pay debt service. Yet these countries tumbled into high inflation and political instability.  Eventually, the US brokered a package of reforms and debt relief.  

It was certainly wrong in Poland in 1989, when Soviet-era debt was killing hope, creating high inflation, threatening to kill the nascent post-communist democracy in the crib.  I was Poland’s economic advisor at the time, and I strongly urged that the G7 countries grant debt relief to Poland.  The US quickly and wisely agreed. The other G7 countries soon joined the US.  Germany joined last, but Poland did get its debt relief, and its economy recovery and new democracy thrived.

It was wrong to insist on full debt servicing by Russia in 1992, when Yeltsin inherited a bankrupt post-Soviet economy.  As in Poland in 1989, I strongly urged debt relief for Russia.  Yet this time, the US, Germany and others rejected the advice. The consequence was that Russia experienced several years of financial upheaval and instability, resulting in the public’s loss of faith in the new and fragile democratic institutions. The West’s approach towards Russia fostered a nationalist backlash inside Russia, similar to the backlash in Weimar Germany to the harsh postwar reparations.  

My point is that believing that indebted sovereign governments should always service their debts is a good working principle nine-tenths of the time, but can be a disaster the tenth time around.  We must not push societies to the breaking point, even when they have only themselves to blame for their indebtedness.    

Did postwar Germany “deserve” the Marshall Plan?  No.  Was the Marshall Plan and the 1953 debt agreement wise policies to give Germany a fresh start?  Yes.  Did Russia “deserve” debt relief in 1992?  No.  Would it have been wise to offer Russia such relief?  Yes.

Does Greece “deserve” debt relief?  No.  The Greek economy has been badly managed for a long time.  Would debt relief for Greece be a good idea?  Yes.  

Greece borrowed too much; failed to crack down on cronyism and corruption; and failed to foster new, competitive industries.  The result is that Greece cannot service its debts in full. The economy is broken.  The export base is too narrow to allow the country to pursue export-led growth - as done successfully in Ireland and elsewhere.  The banks are broken, so firms can’t get working capital to retool.  Greece is in a death spiral of austerity, de-capitalization, brain drain, capital flight, and growing social unrest.  

How do I know?  I have watched daily for six years, and have tried to help several Greek governments – left, right and center – to have an intelligent settlement with Germany and the rest of the Eurozone to foster a recovery.  Yet in my experience the German Ministry of Finance has not searched for a true solution during all these years.  

Greece has an economic crisis no less dramatic that Germany faced under Heinrich Brüning in 1930-33.  The unemployment rate is equal to 27 percent; the youth unemployment is equal to nearly 50 percent; output is down by 30 percent; the banks are in panic and collapse.  Greece is at the breaking point.  Germany can give Greece all of the lectures it wants and make all of the demands that it wants, but Greece will collapse if it is forced to service all its debt and cut public spending accordingly.  These policies are impossible to pursue - as was also the case in Germany under Brüning. As a result no democratically elected government in Greece will be able to survive for more than a few months at a time. The current path will only lead to disaster for Greece.  

The German taxpayers believe that they have been extremely generous to Greece, giving Greece repeated financial loans.  Yet this is partly a mirage.  The taxpayers have been generous to their own banks, not to Greece.

Greece was required to use the first bailout of 100 billion euros in 2010 not for itself but to repay loans to banks, mostly German and French. Greece was similarly required to use the second and third bailouts to repay debts to external creditors.  Hardly any of the bailout funds were used to support the investment that Greece needs to achieve export-led growth or to meet urgent social needs.

Now Greece will get a fourth package, once again to be used to repay the IMF, ECB, European Financial Stability Fund, and other creditors, as well as to put money into its failed banks.  Yes, the German taxpayers have been generous – to Greece’s creditor banks and other institutions, not to the Greek people.  

Debt servicing, in short, is a shell game: give Greece tens of billions of euros every couple of years so that Greece can repay the debts that it owes.  Professionals call this policy “pretend and extend.”  The problem is that the debt grows; the Greek banks die; and the Greek small and medium enterprises collapse.  The brain drain from Greece continues.  It is death by debt. The strategy did not work for Latin America in the 1980s, and it will not allow Greece to escape its economic death trap.  

In short, when a crisis is as deep as Greece’s, the most powerful creditor on the scene has historic responsibilities.  Germany must help Greece to make a new start, not to collapse.  Germany needs to act and grant partial debt relief to Greece, in the name of European prosperity, democracy, and unity.

Of course, such debt relief must be accompanied by major structural reforms in Greece. However, as Germany knows all too well thanks to its own Agenda 2010 reforms enacted under Chancellor Schröder, reforms to the labor market, public administration, the judiciary, or the opening of “closed professions” take time to translate into higher economic growth. Back then Germany breached the Maastricht criteria in conjunction with its own the reforms. Today, Greece, in vastly worse shape, needs debt relief in order to succeed in its reform efforts.

Süddeutsche Zeitung

} Page 1 of 5