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Flawed rescue threatens integration

by Athanasios Orphanides

Flawed rescue threatens integration

The mismanagement of the euro crisis has its roots in the euro area’s flawed political structure. A study of the European Union and International Monetary Fund programme imposed on Greece in May 2010 highlights both the nature of the problem and the difficulty in resolving it.

Governments of some member states – particularly Germany – were able to exploit problems in others to support their own interests. Furthermore, key governments were able to exert undue influence on the IMF, compromising its role to the detriment of other member states and the euro area as a whole.

The May 2010 programme was the original sin of the euro area crisis. Rather than help Greece, it was designed to protect specific political and financial interests in other member states, above all France and Germany.

The ease with which the euro was exploited to shift losses from one member state to another, and the absence of a corrective mechanism, render the current framework unsustainable. In its current form, the euro poses a threat to the overall project of European integration.

Given its accumulated experience, the IMF could have helped contain the crisis and resolve it effectively. By applying its established lending framework, it could have guided a successful programme.

However, its role was counterproductive. The IMF circumvented its own established rules by introducing a flawed ‘systemic exemption’ to its lending framework. Using a legitimate concern – the risk of contagion – as a pretext, it underwrote a programme that shifted crisis losses to Greece that other euro members could have borne. This precipitated the country’s economic collapse and created a poor precedent for subsequent crisis mismanagement in the euro area.

At the end of 2009, Greece faced questions about the sustainability of its government debt, becoming the first euro area member state to require IMF assistance. It faced many of the macroeconomic problems commonly encountered in countries turning to the IMF. Accumulated populist spending had led to sustained budget deficits and current account deficits, a loss of competitiveness, and an overvalued real exchange rate. 

Greece’s euro membership created additional challenges – the government had relinquished control of its own monetary and exchange rate policy, tools it could have used to defuse the crisis.

The design and implementation of an IMF programme for Greece required coordination with other euro area governments and institutions. The resulting complications led to decisions that transformed the problem. What could have been handled as an ordinary IMF programme became a systemic euro area crisis. The Greek programme effectively became subject to the approval of each of the other euro governments, making decision-making dependent on other states’ competing and conflicting financial and political interests.

The need for proper crisis management 

Every crisis generates losses. Proper crisis management should minimise the total economic cost and manage a fair distribution of losses across time and across stakeholders. However, no institution or government in the euro area has the responsibility or authority to take such decisions.

Political survival of elected governments demands that leaders focus on voters and public opinion in their own state, regardless of whether this leads to decisions that are harmful to other states and the euro area as a whole. This creates incentives for diverting losses among different groups of stakeholders and different euro members.

The result was unfortunate but predictable – massive economic destruction in some member states, and a considerably higher total cost for Europe as a whole.

Chart 1, below, suggests the consequences of the mismanagement for the euro area as a whole. The economic performance of the euro area and the US developed in parallel during the first decade of the euro. Yet since the euro crisis began, performance has diverged significantly.

Using the US as a benchmark of what could be achieved in the euro area with reasonable macroeconomic policy and crisis management, the data suggest that crisis mismanagement has generated a sustained annual loss of about 10% of GDP per person. Chart 1 (1)

Winners and losers

The crisis has created winners and losers among euro area member states. Germany has been by far the biggest, and perhaps the only, winner. 

Chart 2, which compares data and projections for the four largest euro member states, together representing around 80% of euro area GDP, reveals large and sustained differences between these economies. Among these, Germany is the only one that appears to have satisfactorily recovered from the global financial crisis. France has fallen behind and only recently recovered to  pre-crisis per capita GDP levels. Spain and Italy have performed considerably worse.Chart 2 F

Chart 3 presents another comparison with the US, and suggests the extent to which euro mismanagement has benefited Germany to the detriment of the rest of the euro area.

Chart 3 F

Taking the US performance as a benchmark, the euro crisis has created a persistent 15% gap in GDP per person between Germany and the rest of the 12 countries that originally formed the euro area. The Greek picture is still more dramatic.

Chart 4, which compares quarterly real GDP data for Germany, Greece and the euro area as a whole, indexed to 100 at end-2007, underlines the catastrophic consequences of the May 2010 programme. Real GDP in Greece has declined by more than a quarter, a destruction of Great Depression proportions.Chart 4 F

Common weaknesses

To be sure, Greece had serious problems in 2009. But Greek weaknesses then were similar to problems commonly encountered among IMF lending applicants and successfully tackled by the IMF. The IMF provides loans subject to conditionality, which is usually unpopular.

With a properly designed programme, the hardship imposed is normally smaller than that which would emerge without the Fund’s involvement. IMF programmes invariably prescribe fiscal austerity. But it is recognised that austerity beyond a democracy’s breaking point becomes counterproductive.

In view of Greece’s euro membership, the intra-euro area nominal exchange rate had to remain fixed. As a result, more of the adjustment burden had to occur via internal devaluation – a relative decline in domestic prices and wages. This is a slower process than an adjustment through nominal devaluation, suggesting that a successful IMF programme might have required a more gradual fiscal adjustment to avoid an austerity-induced economic collapse.

Greece’s relatively high initial level of debt was another vexing issue. By the time Greece turned to the IMF for assistance its debt had risen to 115% of GDP, partly because euro area government bond yield convergence, lowering debt financing costs, helped to encourage deficit financing.

The IMF questioned the sustainability of Greek government debt. But the May 2010 programme was implemented without any debt restructuring, largely reflecting the preference of France and Germany, which took a leading role in the programme’s design.

The programme called for an unprecedented fiscal adjustment of around 15% of GDP. The fiscal consolidation in the baseline scenario envisaged the primary balance improving from a deficit of 8.6% of GDP in 2009 to a surplus of 6% by 2014 and beyond. Although the absence of exchange rate flexibility would have called for a more gradual fiscal correction, public opinion in Germany demanded the opposite – harsher measures to facilitate parliamentary approval without discomfort for Chancellor Angela Merkel.

From Germany’s perspective, as long as IMF staff could maintain that the programme would succeed, the harsher the austerity measures the better. The IMF deemed that the associated decline in economic activity would be relatively benign and short-lived.

According to the baseline scenario, while output was expected to contract in 2010-11, growth was expected to recover to 2.75% in 2015. Overall, the IMF staff appraisal of the programme, and of the level of backing by the Greek government, was very positive: ‘The new Greek authorities have risen to the challenge by embarking on a bold multi-year programme that is extraordinary in terms of the scale of planned adjustment and the comprehensiveness of reforms.’ In the event, the Greek economy collapsed and the EU/IMF programme failed.

Charts 5-9 (p. 15-17) compare the baseline scenario of the May 2010 programme with subsequent outcomes. Data and forecasts for the baseline scenario are taken from the May 2010 IMF staff report. Outcomes are taken from the IMF’s April 2015 World Economic Outlook.

Chart 5, which compares the projected and actual paths of the Greek government deficit, suggests that Athens generally implemented austerity as planned. But as Charts 6 and 7 underline, this fiscal austerity was not accompanied by the envisaged relatively benign recession. Rather than peaking at around 15%, as assumed, unemployment jumped to over 25%. Rather than return to growth in 2012, real GDP continued to decline.

Chart 5 F

 Chart 6 F


Chart 7 F

Measured in 2010 euros, the path of actual real GDP has remained at around €50bn per year below the 2010 projections, resulting in a cumulative output loss to date approximately equivalent to a full year’s GDP.

Chart 8 shows a corresponding deviation in projected and actual nominal GDP. As a result of the output collapse, Chart 9 shows that debt-to-GDP projections proved wide of the mark.Chart 8 F (1)


The saga has been marked by attempts by euro area politicians to shape public opinion in a manner favourable to their own interests and aspirations.
In democracies, crises offer fertile ground for demagoguery. Politicians in different member states have attempted to avoid blame and, if possible, shift it to others, generating considerable animosity and mistrust. Supporters of the Berlin and Athens governments have developed markedly different narratives of events.

Chart 9 F (2)

The Berlin narrative lays down that German taxpayer money has been financing Greek profligacy since 2010. According to this account, Greek governments since 2010 have consistently failed despite generous support from Germany. Athens has no choice but to engineer further austerity measures to honour its commitments – otherwise, Greece should no longer be part of the euro. 

The Athens narrative runs differently: Germany exploited its power to block an ordinary IMF programme, and instead supported a plan that imposed excessive debt on the Greek people while protecting German interests.

According to this account, austerity policies have pushed Greece into a debt trap. As a result, the German government should accept its responsibility and agree a compromise that eases Greece’s debt burden.

Which version is closer to reality? Arguably, both narratives contain elements of truth as well as distortions. However, one telling comment on the circumstances of the Greek programme provides an important indication of the motivations behind what happened.

On 18 May 2010, just one week after the EU-IMF programme was decided, former Bundesbank President Karl Otto Pöhl expressed serious doubts about the programme’s wisdom, questioned whether Greek debt was sustainable, and backed debt restructuring to lighten the burden.

Other observers and analysts expressed similar views. Pöhl disputed official explanations as to the programme’s rationale, and observed that it was guided largely by the need to protect French and German banks, ‘especially the French banks’, from debt write-offs.

Why did the May 2010 programme rule out a restructuring of Greek debt if this, or a similar measure, was required for its success? A restructuring presented an economic cost to French and German interests, as well as significant political risks for Merkel’s government.

As an example, consider the case of Hypo Real Estate (HRE), a bank the German government had bailed out and subsequently nationalised in 2009. At the time, HRE had exposures of around €10bn in Greece and €58bn in Spain, Portugal and Italy combined. A restructuring of Greek debt would have probably caused HRE to collapse.

A second bailout of the bank, while it was already under government management, could have generated such a public outcry as to amount to political suicide for Merkel.

Lessons to learn

In June 2013, the IMF published an evaluation of the failed May 2010 programme that identified numerous flaws and all but confirmed the outsized influence of protecting other interests.

Critical technical errors included overly optimistic assumptions. The report noted that IMF staff had made clear from the outset that risks were such that debt was ‘not judged to be sustainable with high probability’. But debt restructuring was ‘ruled out by the euro area’; a ‘systemic exemption’ was introduced to the lending framework as a justification for ruling out debt restructuring.

Among possible lessons, the report noted that ‘earlier debt restructuring could have eased the burden of adjustment on Greece and contributed to a less dramatic contraction in output. The delay provided a window for private creditors to reduce exposures and shift debt into official hands. This shift occurred on a significant scale and left the official sector on the hook.’

Available information suggests that IMF management was fully aware that the Greek programme that its board approved on 9 May 2010 was doomed to fail; it was already planning subsequent modifications, including a restructuring of the debt for a later time. It has also emerged that numerous IMF board members expressed misgivings about the programme before it was approved.

To ease concerns, the German government publicly announced that German financial institutions would maintain their exposures to Greece once the programme had been approved.

The French government communicated a similar position to the IMF. Had France and Germany honoured these commitments, the programme’s odds of success would have been materially higher.

In the event, once the programme was approved and the restructuring of their holdings of Greek debt avoided, German and French financial institutions reduced their exposures. This included German financial institutions that the German finance ministry had specifically named as having agreed to ‘positively help Greece’s adjustment process’.

In principle, avoiding a restructuring in May 2010 could have represented a desirable outcome for the euro area as a whole. But since most of the benefit of avoiding a restructuring would accrue to French and German interests, France and Germany should have contributed to the resources required to make the Greek programme successful without a restructuring.

For its part, if this reduced the overall losses from contagion, the IMF could have deviated from its normal guidelines and avoided the restructuring to protect stakeholders in other member states, but only if these states’ governments were willing to contribute to an equivalent reduction in Greece’s debt burden.

There is no denying that Greek government policies started the problem in Greece. However, had key governments not interfered with the process, and had the IMF designed a programme that respected its own rules, the Greek crisis would almost certainly have been resolved long ago, without the destruction of the past five years.

Instead, the EU and IMF imposed a programme that was known to be doomed to fail. Prevailing rules were not respected. New rules were devised and implemented to protect specific interests outside Greece.

The May 2010 programme protected German and French financial institutions from financial losses, and Merkel’s government from political costs. But it also led to a catastrophe in Greece and set a precedent for subsequent mismanagement of the euro area crisis.

The euro’s political and economic framework has encouraged conflict over co-operation. This has proven disastrous for the euro area as a whole and ultimately for Europe.

Athanasios Orphanides is Professor of the Practice of Global Economics and Management in the Sloan School of Management at the Massachusetts Institute of Technology and a member of the OMFIF Advisory Board. Between May 2007 and May 2012, he served as governor of the Central Bank of Cyprus and was a member of the ECB Governing Council. This essay draws on ‘The Euro Area Crisis Five Years After the Original Sin,’ the author’s Credit and Capital Markets Lecture presented at the 14th Annual Conference of the European Economics and Finance Society in Brussels on 13 June 2015. The complete lecture can be found here.