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By Arnab Das


EXECUTIVE SUMMARY

The extent of the fiscal pressures facing Greece, and the inherent inability of the EU/ECB to handle such crises with the deliberation and conditionality required, suggest the need for IMF involvement if the EU is to avoid a larger, more devastating round of contagion across the weaker tier of eurozone members. The interlinked nature of EMU turns a relative midget – Greece, accounting for a mere 3 percent of the eurozone’s GDP, into a systemic entity. Thus, if Greece is, as RGE believes, “too-interconnected-to-fail,” the EU needs to put theoretical concerns about moral hazard and global prestige aside, involve the IMF and provide a properly tranched conditionality-based support package to stave off a refinancing crisis.

Sovereign Risks, Sovereign Realities

As we have recently pointed out in a series of research pieces at Roubini Global Economics the financial pressures on Greece merely represent the tip of an iceberg. The next leg of the global financial crisis will feature the rise of sovereign risk, especially in advanced economies that run massive budget deficits and have accumulated massive stocks of public debt to jump start economic growth, all while socializing part of the private sector losses. Financial history – as shown in the recent excellent book by Reinhart and Rogoff - suggests that financial crises triggered by excessive debt and leverage of the private sector are followed within a few years by sovereign defaults and/or high inflation that wipes out the real value of public debts – as a severe recession and socialization of private losses often lead to an unsustainable build up of public debt. Default and high unexpected inflation are both a form of taxation - a capital levy on the holders of such public debt.

Greece is also the specific canary in the coal mine for the eurozone as the economies of the other PIGS economies – Spain, Portugal, Italy and arguably Ireland too – suffer of a twin problem of public debt sustainability and external debt sustainability that has been triggered by a loss of competitiveness.

Euro accession and bull-market “convergence trades” pushed bond yields toward German bunds for the PIGS members of the EMU: the ensuing credit boom supported excessive consumption growth and a fall in savings. Also, most of these economies suffered of a loss of market share towards low-wage Asia, China and Turkey given their low-value added and labor-intensive exports; then a decade of wage growth exceeding productivity growth led to a real appreciation (real exchange rates based on unit labour costs sharply rose for the PIGS), a loss of competitiveness and large current account deficits. In Spain and Ireland, the external imbalances were exacerbated by a housing boom that reduced national saving by sparking a consumption boom and increased residential investment, thus sharply widening the external deficit. Large fiscal deficits and chronic low rates of private savings in Greece and Portugal added to the external deficits. Finally, the appreciation of the euro in recent years – driven in part by an excessively tight monetary policy by the ECB provided the final nail in the coffin for their competitiveness.

Thus, fiscal adjustment will not be enough to avoid a financial crisis. Restoration of external competitiveness is also necessary to restore sustained growth and to improve the cyclical and structural components of the fiscal deficits. There are only three ways to restore competitiveness: first, a decade long deflation (reduction in traded goods prices and domestic private wages) that would be associated with a persistent stagnation of economic growth and thus would eventually become – like in Argentina – politically unsustainable and lead to devaluation (exit from the EMU) and default. The second option is acceleration of structural reforms that increase labour productivity while private and public wage growth is kept in check; but, as the experience of Germany suggests - when it achieved such real depreciation via massive corporate restructuring - this process would take at least a decade to be successful. And it is very hard politically to push for such reforms – with their frontloaded costs in terms of structural upheaval while their benefits are achieved only over a decade. This is particularly true in an environment where growth is very anemic. As the failure to implement the Lisbon agenda of structural reforms suggests that the political and social body may not accept such rapid and radical restructuring.

Third, a weaker euro would help if the ECB were willing – quite unlikely - to ease monetary policy further to allow a nominal and real depreciation of the euro. The fall of the value of the euro from US$1.50 to a level below US$1.40 following the Greek sovereign woes helps; but a euro down to US$1.20 or even lower would be necessary to restore some of the PIGS competitiveness. Still, even a weaker euro would not eliminate the need for structural reforms in the PIGS as otherwise the benefits of a weaker currency in terms of export market shares would accrue mostly to countries like Germany that have undertaken those painful reforms to restore competitiveness via a reduction in relative unit labor costs. So a weaker euro does not obviate the need for structural reforms.

The credibility of a policy of fiscal retrenchment and structural reforms aimed at increasing productivity growth would be vastly enhanced by a shadow IMF program or, even better, an actual IMF program. Under the former scenario the EU Commission would impose fiscal and structural conditionality on Greece while the ECB (and possibly other EU bodies) would provide financing, either directly in the form of lending of euros to Greece or provision of guarantees to the debt of the country (as has been recently rumored). External financing/liquidity is absolutely necessary as it will take time – even for a government otherwise committed to fiscal adjustment and structural reforms – to regain its lost policy credibility while there is lingering risk of a run on public debt given the ongoing budget deficit and the refinancing needs of the public debt coming to maturity and in need to be rolled over. Put another way, when your fiscal and reformist virginity is lost because of decades of deviant misbehaviour, repeated announcements of born-again fiscal and reformist virtue lack credibility until actual abstinence restores reputation over time.

Too Late to Avoid Stigmata

Unfortunately, in the next few months Greece is expected to have to rollover about €50 billion of debt on top of financing a budget deficit that will be – given current adjustment plans – still close to 10% of GDP. Moreover, liquidity/financing may be necessary to stave a speculative attack on the public debt reflected in the recent explosion in CDS spreads.

Announcing a fiscal adjustment program is not sufficient to restore credibility as markets will be sceptical of the political ability to implement it – as demonstrations in the streets, riots, strikes, parliamentary foot-dragging of reforms and fiscal retrenchment and other obstacles will make even the best conceived program subject to bumps of uncertainty about its actual implementation: thus, a non-linear restoration of policy credibility is subject to the risk of a financing crisis as sceptical markets test the willingness of a sovereign to tough it out; thus large scale financing is crucial to prevent such refinancing crisis while policy credibility is restored over time.

In other terms, in any financial crisis markets and investors are uncertain on whether a country is only illiquid or also insolvent. As it takes time to figure out whether this is a crisis of insolvency or illiquidity – as the political willingness/ability to adjust/reform determines that outcome – illiquidity can tip a solvent but illiquid sovereign into actual insolvency if a refinancing crisis does occur. So as a country tries hard to convince investors over time via its policy actions of its solvency it needs to prevent illiquidity from derailing its recovery into an insolvency crisis with appropriate amounts of liquidity that prevent a self-fulfilling run on its debt.

The hydra-headed EU lacks the ability to credibly manage its messaging to markets and generally has failed to impose conditionality on its members, though it has been more successful imposing conditionality on applicants striving to meet political, legal, macro and structural conditions of full membership. But these were countries that desperately wanted to accede to the EU, and so were eager to meet the Copenhagen Criteria and harmonize their own legal systems with the requirements of the acquis communautaire. But when it came to economics, both macro and structural criteria were designed, implemented and conditioned on IMF and World Bank programs alongside the applicants' accession programs.

The EcoFin and European Council, led by Germany, were even able to keep Greece out of the first wave of EMU entrants in a decade ago because it clearly did not meet the fiscal/debt criteria and was judged not to be competitive enough; indeed, a devaluation of the drachma was imposed upon rejection of its initial application in 1998 and fiscal adjustment was required. Similarly, they elected to keep Poland out of the third wave of EMU expansion in 2012, using a miniscule deviation in the inflation rate from target as a pretext.

But once countries had become members of the eurozone club, it generally proved far more difficult to keep them on the straight and narrow, and to maintain the macroeconomic balance demanded by the Maastricht Treaty, as is now clear across the PIGS, with deteriorating competitiveness and mounting fiscal challenges. Systemic eurozone countries violated the strictures of the Growth and Stability Pact with impunity - EcoFin and the Council were unable to impose fines. After all, if the members imposed fines on Italy one year, what if France or Germany were found in violation of the criteria the next?

This history conclusively undermines the credibility of an EU-only financing and adjustment program in the case of Greece. Today, it is obvious that even tiny Greece is systemic (i.e., “too-integrated-to-fail”) because of contagion to the other PIGS. The eurozone is an interested party and will be conflicted in assessing Greece's progress. A failure by the eurozone to sign off on the conditions would spark a new wave of contagion and undermine the euro immediately. If it does sign off even if the adjustment is inadequate, that might allow for short term relief against political pressures, and create room for further relief rallies in the markets. However, a day of reckoning would still arrive later on because of an inadequate adjustment. This is precisely what happened in the case of Russia - the IMF kept lending to Russia for a while despite repeated failures to meet conditionality; eventually the IMF pulled the plug, the market collapsed, and Russia defaulted. But here and now, can anyone really believe that the eurozone will pull the plug on itself?

The draconian fiscal adjustment and market stabilization in Ireland may be interpreted by eurozone policymakers, member states and market participants as reason to think that a fiscal adjustment plan with some sort of contingent guarantee will do the trick for Greece. However, Ireland entered the crisis with a far better fiscal history than Greece, and entered the eurozone with a far more flexible and competitive economy than Greece. This was acknowledged by Ireland's revaluation on entry to the eurozone. And today, Ireland has cut fiscal spending and public wages despite having a far lower public debt. It remains in dire straits, of course, but for various reasons, Ireland’s fiscal plans so far have been judged as adequate by the rating agencies, the markets and the eurozone. Ireland in short, does not need external credibility enhancement in the form of a measurable adjustment plan. But Greece, which has repeatedly violated the rules of the eurozone and whose government has mis-stated the size of the public sector balance sheet problem, clearly does.

ECB financing carries other risks in that it may very well be perceived as a form of bailout (the ECB is in the business of monetary policy not of providing IMF style of conditionality lending to countries in trouble) going through a formal IMF program that includes loan conditionality and significant provision of financing may be the better approach. And provision of liquidity to prevent a self-fulfilling run on Greek public debt or speculative attacks on such debt would be essential as the experience of successful IMF programs suggests: liquidity without policy adjustments/reforms will fail (as the experiences of Russia and Argentina suggest) but policy adjustment that takes time to be credible without financing/liquidity may fail as well. The most successful programs in the presence of a risk of a fiscal and/or external debt financing crisis were those – like Mexico, Turkey and Brazil – where increasingly credible commitment to adjustment and reform was beefed up by a large amount of Colin Powellesque “overwhelming force” liquidity/financing support by the IMF. Greek authorities and the EU had until recently stubbornly and mistakenly denied the need for financing under concern that it would signal weakness and stigma; but partially credible adjustment without financing is more fragile and liable to fail than having a war chest of liquidity to prevent a run on public debt while the appropriate policies are implemented over time with greater credibility.

Tranche Warfare

It is possible that the financial support by the EU could take the form of an EU or German guarantee of Greek public debt conditional on the country implementing a significant fiscal adjustment. But loan guarantees are a poor way of providing conditional financial support. In IMF programs, the financial support is tranched based on achievement of certain fiscal and reform adjustment targets and the amount of support that is front loaded can also be properly modulated. Support in the form of conditionality-based loan guarantees is more problematic to design: your either provide the guarantees or you don’t provide them and making them conditional on achieving over time certain policy targets is very difficult to implement. What if the country is on track and receives the guarantees and then goes off track: do you keep the guarantees or you remove them? And if you remove them, what are the market consequences of such switch? Tranched conditionality lending by IMF is a much more effective way to balance and modulate over time carrots and sticks. Loan guarantees are a more discrete and less flexible way to impose effective conditionality.

Certainly a Plan A with no financing – i.e. imposing draconian fiscal conditionality on Greece by the EU with no provision of money/financing – would be highly likely to fail even if the adjustment/reforms are implemented as trigger happy investors will trigger a refinancing crisis; and then relying on Plan B – a concerted EU/ECB rescue effort when Plan A has failed – would smack of panic and bailout. Better to provide liquidity early before desperation sets in rather than too late when it becomes counterproductive.

The lesson of previous financial crises is also that the provision of liquidity should be large (again, Powell’s doctrine of overwhelming force) and front-loaded in order to have its catalytic effect of preventing a rollover crisis while reforms and adjustment are implemented. Indeed, IMF programs in the East Asian crisis were too small and not front loaded enough (in South Korea, Thailand and Indonesia) thus exacerbating the liquidity run. The IMF learned this lesson and the most recent IMF programs in the recent financial crisis have been a large multiple of country quota: While South Korea got only $10 billion in 1997 even a tiny Romania, whose GDP is a fraction of South Korea’s, recently received a US$20 IMF program. Similarly, IMF programs in Latvia, Hungary, Ukraine, Pakistan, etc. have all been Powell-style. Realistically Greece may need a program in the US$40-50 billion range to stave off a refinancing crisis. Of course, money without adjustment/reforms leads to eventual default and failure (witness Russia, Argentina, Ecuador) but policy change without money on the table is also likely to fail.

Indeed, the risk of a refinancing crisis on public debt shares similar elements similar to speculative attacks on fixed exchange rates that become successfully if a country does not have enough forex reserves to prevent the attack from succeeding as it moves to improve its policy fundamentals. Currently, it is very easy for investors/speculators to push the sovereign spread higher and higher: in the CDS market large amounts of leverage and protection against a sovereign can be built with very little cash in advance as margin requirement is ridiculously low. Recent market pressures on Greece sovereign risk premia have come from three main sources, all of which reflect doubts about Greece’s ability to roll over its debt and about the eurozone’s institutional capacity and political willingness to provide support:

• Hedging of underlying government bond exposures by leveraged agents, mainly European banks, which probably accounted for a major share of the surge in CDS spreads, as these banks sought to reduce their exposure to default risk
• Speculative punting by leveraged agents taking a directional view on Greece risks, mainly by global bank proprietary trading desks and hedge funds. For this category of market participant, substantial leveraged bets can be built with very little cash upfront or margin requirements (at least for those hedge funds who have regained access to leverage in the markets).
• The consequent rise in secondary market yield spreads for Greek Government Bonds over German bunds and rising primary auction yields, as “real-money investors” and banks require a higher default risk premium to roll over existing debt and cover the rising deficit.

Thus, the risk of a self-fulfilling unsustainable debt dynamics – while a country is attempting a credible primary fiscal adjustment – are very large: even a significant reduction in cyclical and structural primary deficits cannot prevent an increase in the deficits and public debt if a speculative-induced spike in sovereign spreads lead to a sharp increase in the public debt interest bill. And such spikes in sovereign spread further destabilize public debt sustainability as they tip such an economy into a recession that increased the debt to GDP ratio. So, failing to move early to prevent an unsustainable spike in sovereign spreads guarantees the failure of adjustment and leads to eventual default.

Until now, investors have had every reason to demand a higher risk premium to finance Greece’s rising debts and deficits, and speculators have had a field day punting Greek CDS spreads to ever higher levels. Both have dramatically and rapidly increased the risks of a refinancing crisis. Until now investors/speculators have had a field day kicking the Greek CDS spreads to ever higher levels trying to trigger a refinancing crisis. If Greece does not have a war chest of euro liquidity to strike back, thus triggering a short squeeze, Greece is doomed to share the fate of countries that did not have enough forex reserves to prevent a speculative attack on their currency peg. A public debt refinancing crisis is thus akin to a speculative attack on a currency. While using even massive reserves to avoid a currency crisis can fail if there is not an improvement in the macro/policy fundamentals that justify the maintenance of a peg the lack of enough reserves can lead to a self-fulfilling currency crisis even in a country that is improving its fundamentals. The same holds for speculative attacks against the short term debt of a government that needs to be rolled over. Adjustment without liquidity is bound to fail.

And liquidity allows the government to induce two-sided risk on sovereign spreads and avoid a vicious circle where speculators succeeds in one-sided and destabilizing bets on such CDS spreads. And liquidity allows the government to induce two-sided risk on sovereign spreads and provide time for fiscal adjustment to come through by avoiding a vicious circle in which the combination of exposure reduction and speculation raises risk premia to one where a debt trap is inevitable.”

Enter the ‘Preferred Creditor’

An IMF program is necessary and desirable for a couple of other reasons. First, the IMF can lend to countries with any rating – even to countries in default under the terms of its “lending into arrears” policy as the IMF enjoys of a de facto – if not de jure – preferred creditors status; so the IMF could help Greece even if further rating downgrades force the ECB to stop using Greek debt as a collateral for its repo operations. There is indeed a serious risk next year that, as the threshold for such collateral rises from BBB- to a higher rating, Greece will fail to qualify for ECB repo support and thus experience a refinancing crisis. Conversely, the ECB lowering its threshold for the collateral will smack of a bailout and would be politically damaging for the independence and credibility of the ECB. Second, the IMF has 60-plus years of experience playing “bad cop” or “tough doctor,” taking the “blame” for forcing countries to take the necessary bitter pills of adjustment and reform and helping basket case countries by providing them with conditionality based lending. The ECB and EU have very little such experience and, politically, playing bad cop is hard to do (see the past failure of the EU to impose fines on fiscally deviant countries). Also, any financial support needs to be tranched and conditioned on achievement of fiscal and reforms role; thus, providing financing via the ECB that is tranched and conditional would smack of using an independent monetary policy authority to achieve fiscal bailout goals.

The EU, the ECB and many commentators also wrongly over-emphasized the moral hazard problems of any financial support of Greece or other countries in trouble. First, financing without policy change is itself moral hazard-ridden and anyhow eventually bound to fail. But financial support conditional on fiscal adjustment and policy reforms minimizes moral hazard distortions.

Second, while fiscal adjustment is necessary to avoid a spike in spreads and an unsustainable debt dynamic, the short term effect of a large fiscal deficit reduction can be counterproductive and exacerbate the growth contraction and even lead to a recession. This is the case when the short term benefits on growth of a potentially delayed reduction in spreads and improvement in overall credibility are smaller than the fiscal drag of a massive reduction in public spending and increase in tax revenues. While some large fiscal consolidation episodes in the past of the EU (Ireland and Denmark in the 1990s) crowded in growth even in the short run rather than crowding it out there is a risk that excessively front loaded fiscal adjustment in a time of recession, turmoil and weak demand leads to a worsening of the growth outlook with destabilizing effects (an example being Argentina when repeated fiscal consolidation policies in 1999¬2001, however necessary to restore fiscal credibility, became destabilizing and made the recession and deflation worse, eventually undermining the policy adjustment and leading to default and currency peg collapse).

Thus, one of the benefits of a credibly designed and implemented IMF program is that, if the country credibly commits to fiscal reforms that will be phased in only over time, it can get a modest fiscal relief in the short run – smaller pace/speed of deficit reduction - if excessively front loaded fiscal adjustment risk undermining economic growth and the success of such program. This is not to excuse a deviant Greece from the necessary front loaded fiscal adjustment it must undertake to restore credibility and sustainability. Rather, it is only a warning that the amount of front loaded adjustment that sceptical investors may require of Greece may be so excessive that the whole program may be undermined. Thus, a carefully designed IMF program with sufficient liquidity can smooth the trade off between the need for short term medium term fiscal consolidation and the need to avoid an adjustment that is in the short term so draconian that the credibility and effectiveness of the program is undermined with destabilizing effects on growth.

Third, rather than exacerbating moral hazard, a properly designed IMF program can reduce moral hazard and induce policy adjustment and reform that otherwise would not occur in the absence of adequate liquidity. Recent academic research (“International Lending of Last Resort and Moral Hazard: A Model of IMF's Catalytic Approach” by G. Corsetti, B. Guimaraes and N. Roubini - Journal of Monetary Economics, 2006) suggests that the probability that a fiscal and reform policy is implemented is greater with IMF financial support than without it. If a government needs to do politically painful adjustment and reforms and such attempts risk to fail because of a refinancing crisis, the likelihood that such government will implement such reforms is reduced as failure is almost guaranteed. Instead, a lot of money of the table increases radically the probability that a policy of adjustment and reform will be successful if implemented – as the risk of a rollover crisis is radically reduced. Thus, IMF programs can reduce moral hazard rather than increase it. An example of such a success is the Brazil policy adjustment in 2002 on the eve of its presidential elections, when markets were concerned about the implications of a victory by Ignacio “Lula” Da Silva, then viewed by markets (quite incorrectly, as it happens) as a anti-market socialist). The US$30 billion IMF program ensured the maintenance of a large primary surplus and the continuation of macro reforms that prevented a bigger crisis from occurring. More recently, the willingness of countries such as Latvia and Hungary to undergo a massive fiscal adjustment to avoid fiscal bankruptcy and a destructive currency crisis has been bolstered by large IMF/external financial support. Whether Greece will turn out like Latvia and Hungary or more like Russia in 1998 depends on the domestic politics of adjustment and reform (i.e. how much the political and social body can take short term pain for long term benefits). But the existence of external financial support would increase the probability that politically painful policy actions will be undertaken rather than delayed.

A European Lehman?

In the end, even if Greece were not politically able to fully implement policies to restore fiscal sustainability and competitiveness, the EU and the ECB will have to partially bail out Greece to avoid a massive contagion of its problems to the rest of the eurozone and to avoid a collapse of the monetary union. A default by Greece could have the same global systemic effects as the collapse of Lehman. Sovereign spreads are already pricing the risk of a domino effect from Greece to Spain, Portugal and other eurozone members. Therefore, in the game of chicken between the Greek authorities and the EU/ECB, the Greeks know that even if their political constraints prevent them from doing sufficient fiscal adjustment and structural reforms, a financial support from the EU/ECB would be unavoidable because the alternative would be a systemic event of a Lehman scale, first leading to massive contagion to the rest of the weak eurozone links and then having global effects. Indeed, recent rumors of a planned EU bailout of Greece confirm the country’s systemic importance.

All else being equal, the Greek side will do less than otherwise necessary or desirable in full knowledge that a Greek default would have systemic effects that the EU/ECB need to prevent. So in some sense Greece knows that it is “too-interconnected-to-fail” and it will be partially bailed out regardless of what its government does or doesn’t do. This fundamental moral hazard problem cannot be fully eliminated. This also implies that Greece – and other eurozone weak links – will do less fiscal adjustment and structural reforms than necessary to avoid an unsustainable debt dynamics. In other terms, if the political constraints as well as the too big to fail distortion lead to adjustment and reform that is insufficient to restore of fiscal and external sustainability and resumption of good economic growth the result will be a policy of muddling-through that prevents a default and exit of Greece from the EMU but does not resolve its fundamental problems: it will be like having a comatose patient on a lift support system that avoids death but also prevents a full recovery of its health.

That approach may be better than a full scale collapse and break up of the monetary union, but it risks spreading the disease from one patient to the other ones nearby. Indeed, in due time Spain and Portugal and later Ireland and Italy, also will get into trouble. The moral hazard bias will be even larger as Spain and Italy tremendously more systemically important than Greece. Thus, the EU/ECB, along with German and French taxpayers, are willing to partially bail out a small Greece as the costs of that bailout are limited and as the consequence of a collapse of Greece is the effective destruction of the monetary union that Trichet, Brussels and policymakers in Paris and Berlin have worked so hard worked to achieve. But the same policy makers’ willingness and ability to follow a bail out of Greece with even larger rescues of - a Spain, Portugal and an Italy (and an Ireland or a Belgium, to boot) would be much more limited. In the end, an eventual breakup of the monetary union may be unavoidable if other members of the PIGS (or PIIGS) do not take early and credible policy actions to deal with their own twin problems of fiscal and external debt sustainability and competitiveness.

Indeed, some of the other eurozone members have greater problems than Greece. Take Spain, for example. While the country has a smaller budget deficit and public debt as a share of its GDP its fiscal

sustainability parameters are rapidly worsening. Also the unemployment rate in Spain is nearing 20% as opposed to a figure below 10% for Greece. Spain also experienced a massive housing bubble that has now gone bust with severe damage to its economy. Also the situation of Spanish banks – in spite of dynamic provisioning – is very shaky: non- performing loans are sharply rising as a share of assets and the excesses of lending in the boom years are now evident in the effective insolvency of many Cajas. Finally, the real appreciation and loss of competitiveness of Spain has been even larger than in the other PIGS as years of real estate bubble-fueled economic boom led to an excessive growth of wages well above productivity growth. Also, the real estate bubble, which resulted in years of high GDP growth, concealed the massive loss of competitiveness that the country experienced. Now that housing has gone bust, it is clear that the Spanish emperor has no clothes. The receding tide has shown that Spain –even more than the other PIGS – was swimming naked.

In the end, if Greece is politically unable to do enough fiscal adjustment to forestall unsustainable debt dynamics – i.e., if it turns out to be insolvent and not just illiquid in spite of a partial financial support from the IMF and/or or the EU/ECB – one solution that is one step short of default (that occurred in Russia, Argentina and Ecuador) may be a coercive restructuring of its public debt – under threat of default - along the lines of what was done in Pakistan, Ukraine, Uruguay and the Dominican Republic. In effect, this would entail a coercive lengthening of the maturity of the debt without face value reduction of the debt (no formal haircut) together with a coercive reduction of the interest rate on the new debt at below markets levels. Such surgical solution would imply some losses for creditors on a NPV basis but much smaller losses and less systemic disruption than an outright default. As the experience of past emerging market crises suggests such coercive restructuring can be designed – even in the absence of collective action clauses – via exchange offers that bypass the need for unanimity in changes in the terms of such public debt.

Still, such a coercive restructuring of the debt would resolve – or push to the longer future – the issue of public debt sustainability. But it would not resolve – in the absence of structural reforms or outright exit from the monetary union – the problem of the loss of competitiveness and the unsustainable external balance. That is why default (or coercive debt restructuring) without devaluation may not be possible and devaluation (exit from EMU) without default may not be possible either.

In conclusion, the EU and ECB are correctly worrying about the moral hazard of any “bailout”; but to reduce that moral hazard a credible IMF program that tranches financial support with the progressive achievement of fiscal and structural reform goals is the right if risky solution. An IMF solution can also better minimize the moral hazard problem than an approach based on loan guarantees. Thus, to avoid the fate of Argentina a credible program of fiscal consolidation and structural reform backed by a large IMF program is the right path to be taken to teach Greece and the other PIGS how to fly. Those PIGS may never learn to fly if the political willingness to adjust and reform is not there in which case the EMU will eventually break up; but relying on the IMF may be for the time being the least bad of many bad options.

Nouriel Roubini is Professor of Economics at the Stern School of Business at New York University and Chairman of Roubini Global Economics, a global macroeconomic consultancy.

Arnab Das is RGE’s managing director of market research and strategy.