The IMF published yesterday a preliminary analysis on the debt sustainability of the Greek government. The timing of the publication, a couple of days ahead of the referendum, has triggered a variety of interpretations of the conclusions. The Greek government has quickly jumped to argue that the results confirm that government debt in Greece is not sustainable and a substantial haircut is needed.
Is the interpretation of the Greek government correct? Yes and no. The IMF analysis suggests that under reasonable assumptions on growth and interest rates for Greece, it is very difficult to imagine a path of primary budget surpluses that makes the current situation sustainable. This is what the Greek government says and in that sense it seems that the IMF is providing empirical support to their claims. However, the analysis is full of other subtleties that do not warrant this quick conclusion and that in some cases contradict the views of the Greek government.
First, the report makes it clear that since Syriza came to power the situation has deteriorated because of a combination of lower growth, lower privatization revenues and a worsening of budget balances. So here the IMF seems to support the German (and others) view that the situation would be better if the right policies were applied. The need for haircuts is partly the responsibility of the current Greek government.
Second, there is nothing new in the IMF analysis and almost everyone agrees to it, including the other Euro partners. The real issue and where there is possibly some disagreement is on how to deal with an unsustainable level of debt. Here is where the subtleties start.
Let's go back in history first. In 2012 it was also clear to most that Greek debt was on an unsustainable path. Because of this the Euro partners and bond holders agreed to a haircut on the face value, an extension of maturities as well as a reduction in interest rate that implicitly reduced the value of the Greek liabilities. How much that reduced debt is debatable but it is likely that it reduced it by about €100 Billion.
But that first restructuring was clearly not enough. What went wrong? Growth never returned, in fact, the economy continued on its path of collapsing changing all the assumptions made by the Troika at the time of the negotiation. Why did growth fail to live up to the assumptions? Because the Troika underestimated the effects of fiscal austerity (in Greece but also anywhere else) and possibly because some of the projected reforms in Greece either did not take place an they did not pay off as much and as fast as planned.
What about going forward? Can we be more realistic regarding Greek prospects of growth? That's what they IMF is doing now. It forecasts growth in Greece to be input 1.5% in the long term. This is what I would say a very pessimistic number (even if it might still be realistic). It assumes that a country that has a GDP per capita of less than 50% of the most advanced economies in the world will fail to converge to that level, in fact it is likely to get stuck at that level or even diverge.
And here is where the Greek government and the IMF projections might be at odds. The Greek government argument is that once debt is reduced and all the reforms are implemented, the Greek economy will take off and start finally growing. But if growth returns, is debt really unsustainable Greek debt is unsustainable because the Greek economy will not grow in the long run (and this is not just about austerity). But if the Greek government is right and the reduction in debt does indeed raise the potential growth of Greece then the current debt level might be closer to being sustainable than what the IMF says. In other words, the IMF tells the Greek government something that they want to hear (debt needs to be reduced) but in an scenario that the Greek government cannot accept (growth is going to be dismal for decades).
The way out of this inconsistency is to make default a function of GDP growth rates. This goes back to the old idea of indexing the value of the debt (or the interest rate) to economic growth (here is a very good description of its virtues from Paolo Mauro). If the Greek government is right and Greece growth prospects are very good, the debtors will get back most of what they are owed. But if the IMF is right and growth in Greece will remain low over the coming decades, the debtors will get a lot less, whatever the low growth prospects allow for.