O BENEFÍCIO DO INFRACTOR

Moral hazard of saving Greece again

By James Mackintosh

Dick Fuld is not a good role model for anyone, least of all the embattled Greek prime minister, George Papandreou. But Mr Fuld, who oversaw the decline and fall of the Lehman Brothers empire, is the obvious parallel for Mr Papandreou, as policymakers and banks fall over themselves to warn that a Greek default would prompt chaos akin to Lehman’s collapse.

There are many similarities in the rise of Greece and Lehman. Both were given far too much money far too cheaply by investors, who paid too little attention to the risks they were running. Both used off-balance sheet structures to hide their growing debts. Both had leaders – Mr Fuld and Mr Papandreou’s predecessors – who had every incentive to keep borrowing and ignore the underlying problems.

There are plenty of differences, of course. Lehman’s extensive art collection was no rival to the Parthenon, and, powerful as Mr Fuld was, he did not have fighter jets under his command.

But the biggest distinction is that Lehman was allowed to fail. Greece, for now, has been propped up.

In that sense, Greece is more like Citigroup, or perhaps – given it has so far only received loans – Goldman Sachs. These too-big-to-fail banks were rescued once Lehman provided a real-life demonstration of systemic risk.

So what happens if the European Central Bank gets its way, and Greece is rescued again? For investors, that would be good news: the risk of default goes away for a while. The danger is that Greece becomes a sort of global benefit scrounger: addicted to handouts and unwilling to work.

The problem is moral hazard. Just as with the biggest banks, Greece knows it is too big to be allowed to fail. Just as with the biggest banks, that means it can drag its feet on reform – right up to the point where lenders, or regulators, come up with a realistic threat.

In the case of the banks, regulators are being given proper powers, which banks are trying to counter with political lobbying. In the case of Greece, though, lenders have few serious threats that would not hurt them as much, or more, than Greece. There is no mechanism for kicking Greece out of the euro, and simply refusing to give the country more money would destroy the credibility of rescues of Ireland and Portugal.

Even when lenders do have leverage over countries, the incentives created by bail-outs end up encouraging hopes of future rescues – and so encouraging bad behaviour in the form of unsustainable borrowing.

According to research by Alma Lucía Romero-Barrutieta, Aleš Buliř and José Daniel Rodríguez-Delgado, published by the International Monetary Fund, the lesson of debt relief to the third world is that it will be followed by rising debts.

They looked at the case of Uganda, given some form of debt relief on average every three and a half years for the 24 years to 2006. It was the first country to have debt cancelled under the heavily indebted poor countries initiative, and had further debt cancelled later by international institutions. As a result it reduced debt from a peak of 102 per cent of economic output in 1992 (even then below Greek levels) to just 12 per cent in 2007. It is now rising again.

The researchers argue that the expectation that they will be able to keep writing off debt distorts incentives, by encouraging borrowing and consumption instead of investment. Almost everyone would borrow if they knew they could avoid having to repay. (To some extent the ease of default under US bankruptcy laws may help explain the high levels of both personal and corporate indebtness: it is much less risky to borrow than in countries where bankruptcy comes with legal and social stigma.)

According to the researchers’ model, debt is higher and investment lower than it would have been without debt relief. As a result, the model they built suggests a country receiving debt relief ends up 20 per cent poorer thanks to the distorted incentives.

This is not such a serious issue when private debt markets rule. While bond investors in the eurozone exercised all the vigilance of a Greek tax collector, they do tend to remember miscreants. A country that defaults may be able to borrow again quickly, but will find it harder to borrow to excess.

Greece is currently facing a version of the Ugandan experience. If European governments prove willing to keep extending it loans, why would it want to put its house in order? Only if there is a serious threat money will dry up would it have an incentive to act.

European governments are not managing to provide that incentive, because of the fear that Mr Papandreou could inflict as much damage on them as Mr Fuld did. Finding a way to allow Greece to default without taking down Europe’s banking system, Ireland or Portugal is the only way to allow its future borrowing to be policed properly – preferably by private sector investors who have suffered from the default.