Sunday, June 9, 2013

It's the politics, stupid!

The IMF recently admitted (pdf of report here) that they mis-handled the bailout of Greece, in particular the 110 Euros first rescue package, claiming that growth assumptions were too optimistic and debt restructuring should have taken place earlier, in early 2011. Predictably, this has provoked a strong reaction from the Europeans, who have strongly defended the bailouts. Critics of IMF have pounced on it as further proof, if any was still needed, of its long history of mishandling sovereign debt crises and failure to learn from its mistakes.

Now, I believe that both IMF and the EC are right, albeit for different reasons. From a purely economic perspective, the IMF's argument that Greece did not meet medium-term debt sustainability was plain obvious and that debt restructuring was inordinately delayed cannot be faulted. But the EC's delayed rescue and its management of the rescue package as a compromise may be a reflection of the deeply political nature of such decisions. In fact, even history may bear out the European leaders in positive light if its long-term implications turn out as desired.

For those who followed the intense debates in Europe about bailing out the peripheral economies, it is plain evident that decision makers needed to pull off a very delicate balancing. On the one hand, Greece had lost market access and was on the verge of a sovereign default, even exit from the eurozone, thereby posing a serious danger that the European project would collapse. This imperative to rescue Greece, was matched by the equally compelling opposing argument that Greece's problems were essentially its own creation and a bailout would generate a dangerous moral hazard spill-over to others, besides being legally questionable under the European integration treaties.

In an ideal world, without moral hazard and other market failures, the debts of Greece and its financial institutions should have been restructured much earlier. The delay obviously worsened the situation and made the rescue costlier, both financially and in human suffering. Further, in the absence of medium-term debt sustainability, any bailout would be tantamount to throwing good money down the drain.

But the Europeans (and rational economists too) would see that as the psychological deterrent cost, which presumably others have internalized, of minimizing the moral hazard. Further, it may also have been the political cost required to convince both parties to accept the terms of bailout - for Greek politicians and its citizens to accept the harsh austerity that came with the rescue (Greece's failure to comply with its structural reform commitments agreed in mid-2010 is proof of this), and for Germany and other creditors, political support to use their taxpayers money to help Greece. These costs may have had to be incurred to mitigate the ever-present bias towards a repeat of the events that led to the crisis.

Finally, the bailout happening despite Greece not being on a medium-term debt sustainability path was not surprising, since the decision to bailout Greece was a purely political one. It is inconceivable that the European decision makers were unaware of Greece's perilous finances and therefore the inevitability of further bailouts. In fact, the multiple drips of bailouts, instead of single shot of big-bang rescue, may itself have been part of the calculus of managing the aforementioned psychological and political costs.

In view of the aforementioned reasoning, analysts are off the mark in suggesting that the IMF's latest admission would form the template for future rescues. It would not, because all such decisions are more political than technical, and the former invariably trumps the latter. And being unaware of that betrays a naive understanding of politics and international relations that govern such decisions. In this context, it is surprising that IMF's ex-post evaluation of its role does acknowledge the political dimension of the joint decision made with EC and the ECB. To that extent, the current acrimony could have been easily avoided.

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