Whose Moral Hazard?

If you think of the Greek debt crisis as a result of “irresponsible lending” instead of irresponsible borrowing, the implications of a Greek default for “moral hazard” change. A debt write down would not just be seen as a bailout, but as a rational adjustment that allows a better allocation of risk between borrowers and lenders.

The conventional wisdom is that Greece overborrowed from bond markets. They lived beyond their means and the chickens are now coming home to roost. As such, allowing a partial Greek default would encourage future prolifigacy. Instead, the troika should hold Greece to their debt promises so as to prevent future moral hazard.

But another way of looking at it is to ask: “who the hell decided to lend to Greece at German-like interest rates”? Even as late as October 2008, the yield spread between Greek and German 10 year debt was under 1%. In the context of a longer history of interest rates, this was absurd. Reinhart and Rogoff’s history of financial crises shows that Greece has been in default for roughly 50% of its history since independence in 1830*!

Under this framework, the debt deal in 2012 was a massive bailout for non-Greek banks. When governments stepped in, private banks had the chance to offload their holdings of Greek debt.

So instead of considering how a Greek bailout will affect the Greek government’s willingness to borrow, think about what a bailout would mean for those investors lending to Greece. Leaving all of the creditors whole could be seen as encouraging international investors to not worry about bond spreads between Eurozone countries. This is yet another form of moral hazard. A failure to write off debt would be a sign that debt repayment will be prioritized over economic growth in future negotiations. This would signal to creditors that they can reach for yield even if they think that low bond yields on potential troublemakers such as Greece are not sustainable.

Instead of insisting on austerity, the move should be to write off debt and then implement substantially higher capital buffers on Eurozone banks. Both steps are important. First, a partial debt write off would allow Greece to get back on its feet. Austerity, instead of substantially reducing Greece’s debt to gdp ratio, has instead caused the debt burden to rise as spending cuts savage the real side of the economy. History shows that these large debt burdens are almost always resolved by either inflation or restructuring. And so instead of letting the suffering drag on, creditors should recognize that the full debt will not be repaid.

Second, higher equity requirements on Eurozone banks would make them better able to withstand a haircut if such debt problems arise again in the future. In addition, this would make the shareholders in the banks bear the burden of overly risky investment decisions, such as buying Greek debt at only a 1% yield premium relative to German debt. As such, it would have the additional effect of disallowing Greece access to excessive amounts of cheap credit in the future.

In effect, instead of focusing on moral hazard from borrowers, this proposal would resolve the pervasive incentives for lenders to buy government debt that they expect to be bailed out.

This approach is better than forcing the burden of adjustment exclusively on the borrowing country. Sovereigns face a diabolic loop in which economic weakness makes debt repayment more difficult, thereby creating a sovereign debt crisis that further damages economic growth. Pressing these countries to pay up when growth is weak threatens to send the situation out of control. Instead, banks should be responsible for appropriate funding structures that allow them to share in the burden of adjustment.

Moralizing is unproductive in a debt crisis. Instead of trying to punish Greece, the conversation should shift towards debt write-offs and higher equity requirements in an effort to restore current growth and establish a more rational risk division for the future.

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