The Greek Crisis: The ECB’s three mistakes in the Greek crisis and how to get sovereign debt right in the future

Monday, May 16, 2011

The ECB’s three mistakes in the Greek crisis and how to get sovereign debt right in the future

by Jeffrey Frankel

Vox
May 16, 2011

It is a year since Greece was bailed out by EU and IMF and there are many who label it a failure. This column says that while there is plenty of blame to go around, there were three big mistakes made by the European Central Bank. Number one: Letting Greece join the euro in the first place

By now just about everybody agrees that the European bailout of Greece has failed (see for example Darvas et al. 2011). The debt will have to be restructured. As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.

There is plenty of blame to go around. But three big mistakes can be attributed to the European leadership. This includes the ECB – surprisingly, in that it has otherwise been the most competent and successful of Europe-wide institutions.

Mistake number 1: The decision in 2000 to admit Greece in the Eurozone.

Greece was an outlier, geographically and economically. It did not come close to meeting the Maastricht Criteria, particularly the 3% ceiling on the budget deficit as a share of GDP. No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.

Mistake number 2: Allowing the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007.

Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany. Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period (Frankel 2007). And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators. But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.