Public debt is very high, public and private investment has collapsed, and the economy shrinks. Official lenders provide the financing needed to service debt. This situation describes not only Greece today, but also the many developing countries in the 1980s debt crises.
This blog post applies the insights of that time provided by Krugman (1988, 1989) and Froot (1989) to the current situation in Greece.
In a situation where the future repayment capacity is exogenous yet uncertain, creditors are better off never to grant debt relief. While the expected value of the repayment may be below the nominal value of debt owed--as is surely the case for Greece--the creditors' claim has some option value. As Krugman (1988) writes, creditors would be "foreclosing the possibility of benefitting from any later good fortune on part of the country."
Creditors have thus the collective interest in postponing the day of reckoning: they keep Greece afloat to avoid an immediate default. The collective action problem arising in cases with multiple debtors is not grave: most of Greece's debt is owed to its European partners and the IMF, containing the gains from free riding that is reaped by the few private bondholders. And given Greece reaches a primary surplus next year, most of new financing needed is actually to spent to service debt! Ergo, Greece is not on the falling branch of a debt Laffer curve, unless...
...the repayment capacity is not exogenous. If the debt overhang leads to underinvestment, reducing Greece's potential output in the future, then a case could be made for forgiving debt today. In the 1980s debt crises, the debt relief in the form of debt rescheduling was found to depress future repayment capacity where there is no new, additional lending supplied. (Froot writes "if investment incentives are present… the optimal debt-relief package will include an infusion of new lending.") However, the Troika programs for Greece have determined the amounts of public investment and provide for their financing. This leaves the question whether private investment is affected by the debt overhang: Greece's low sovereign rating (a C by Moody's) may deter foreign investors, and uncertainty about a future debt restructuring may incentivize domestic savers to invest abroad. Evidence for such debt overhang effect is hard to pin down.
How to solve this trade-off between the keeping the option of full repayment while limiting the adverse consequences of debt overhang? By committing to reduce debt to 124 percent by 2020 and substantially below 110 percent in 2022, the European partners cut this Gordian knot: They keep the option to reap any upside if Greece rebounds while trying to remove uncertainty about Greece's debt stock at the end of this decade.
Will it work? There is a sad tradition among European politicians to duck their previous commitments. Conversely, the commitment could lead to moral hazard on Greece's behalf, which could slow the necessary adjustment or even bring forward debt creating outlays right before the 2020 cutoff.
As usual, nothing is panacea.
Greece debt crisis is quite interesting topic. This year Greece even had budget surplus! So Greece central state received more money by taxes than it spent. Only few countries in Europe can do this. But old problem still remains. Very very high public debt. So even if greece state get some surplus they have to use to to return very large amount of debt. Public debt is around 170% of GDP. This amount money cant be ever repaid. I think that the best way for Greece and Europe will be to "erase Greece debt" -anyway i doubt that Greece will be able to return such amount of money with very high interest rates
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