Germany and Greece have both wisely blinked on how best to renegotiate Greece’s outsized debt to its reluctant playmates inside the European currency union. The present fix will last for only four months, which means that the unresolved issues will surge to the fore yet again if some long-term solution is not crafted in the interim. In dealing with bailouts of this sort, financial gurus unduly rely on macroeconomic principles. In my view, that approach overlooks the gritty transactional challenges that routinely arise when parties attempt to work out delinquent loans in the shadow of bankruptcy. The picture is not pretty.
To see how the process unfolds, start with a simple situation where a lender advances $1 million to a debtor who at the appointed hour is unable to repay the loan in accordance with its terms. At this point, the lender first looks to foreclose on any specific collateral that the borrower has given to secure the loan. But specific assets do not secure many loans, like those made to Greece.
In dealing with these unsecured debts, one option open to the lender is to insist that all the money be repaid, come hell or high water. But if the current funds are not available, these futile and aggressive demands could easily disrupt the debtor’s productive capacity, so that the lender will cut off its nose to spite its face. Backing off on these onerous collection demands, by taking some reduction to the principal or interest, or both. Typically, these revised deals also require delay in repayment, but that haircut, as it is usually called, ultimately works to the lender’s benefit. To see why, do the math: backing down results in a higher probability of collecting a smaller amount. Its present value is often worth more than some lower probability of collecting the original debt with interest in full.
Similar calculations influence the position of the debtor. At one level, it would like to pay no money back on principal or interest, but it knows that if it takes the nuclear option it will cut itself off from all future funds and thus will be worse off than if it negotiated some peace with its creditor.
The net effect of these two forces, both between private parties and between nations, tends to result in a legal composition of claims that has two components. First, the debtor agrees to pay some fraction of the overall claim, while the various co-creditors agree on some division among themselves of the reduced revenues. The hard question is which of the many possible permutations will be the final resting point. Here, basic bargaining theory is clear on only one point. There is no unique solution which states in present value terms how much of the debt will be forgiven and how much will be kept in place. Much of this depends on how the two parties play the game of chicken where each knows that the only question is how many concessions it will have to make. Notwithstanding these stresses, the uniform legal response is to enforce the settlement as written—at least until it falls apart a second time.
One key question concerns the overall implications of these awkward settlements for the financial health of both the creditors and debtors, each of whom have taken a financial hit. The answer depends on the size of the implicit wealth transfer between the parties. In general, the entire process leads to unhappy result. These transactions are costly to negotiate, and the transfer at the end of the game does nothing to improve the productive capacity of either the lender or the borrower, except to stave off disaster.
The hope for some upward bump in output improves when and if the debtor accepts certain conditions on how it will best run its business—or its nation. At the very least, the borrower has to do two things. It must set aside some reserves for repayment, and, more importantly, reorganize how it does business in order to improve output. In dealing with nation states, liquidation in bankruptcy is just not an option. The long-term success of the reorganized country depends on choosing sensible negotiated conditions.
We can now isolate the nub of the confrontation that arises in the case of Greece. There is no magic number that tells how much of the debt should be forgiven this time when some debt has already been forgiven. But two other problems lurk in the background. The first is that in any sensible private transaction, the lender will advance capital to a borrower for it to purchase durable assets that will generate the income for the repayment of the loan.
The recent events in Greece, however, make it painfully clear that the funds it received from other nations in the European Union were largely used to bolster its elaborate internal transfer system, the aim of which is to stoke consumption. The borrowed funds generated income to repay the interest and principal on the debt.
That situation is not sustainable. If Germany and the other lenders make financial advances on the same terms as the previous advances, they will be throwing good money after bad. The Greeks will again fund short-term consumption not long-term investment. One possible way for the lenders to collect their pound of flesh is to demand today a continuation of the austerity regime that the newly elected Greek Prime Minister Alexis Tsipras and his finance chief Yanis Varoufakis have steadfastly resisted. Their successful campaign was based on the promise to repudiate the heavy austerity regime that has led to massive dislocations inside Greece, whose high unemployment rates are untenable in the long run. It is easy to see in this scenario some grim historical patterns. In the aftermath of World War I, the Treaty of Versailles imposed such onerous obligations on Germany that its enforcement contributed to the massive social unrest that led to the catastrophic rise of the Nazi party.
Yet at the same time, to back off of austerity will lead to yet another round of debts that will be written off. The advantageous consequences to Greece of that forgiveness are thus set off by the disadvantageous consequences to Germany and its lending partners. It is no part of a sensible policy to have Greece live beyond its means in the long-run, and then fight over how much of its debt it can export to its lending nations in the next financial showdown. It no wonder that Wolfgang Schäuble, the German finance minister has decided to play it tough by making virtually no long-term concessions. It does no good to bailout the Greeks if that action sinks, or even destabilizes the German economy.
So what then should be done to get out of this death spiral that threatens to envelop both sides to this deal. There is only one answer. The Greeks must heal themselves. The solution here does not depend on austerity, which imposes suffering without positive consequences. Nor does it depend on budgetary and financial reforms of the sort that Greece seems willing to make, notwithstanding rising internal discontent. The solution is to undertake a comprehensive top-to-bottom structural reform of the Greek economy that rests on one simple position: Full steam ahead on deregulation in all markets dealing with capital and labor, which will unlock the productive capacity of the nation. It is here that the rubber hits the road. Greece is legendary for its elaborate set of entry barriers to various trades and professions. It is notorious for the extensive protections that it offers its current workers. And it cannot escape the grim wreckage of a 25 percent unemployment rate that stems as much from these dysfunctional market regulations as anything else.
Deregulation does two things at once. First, it reduces the administrative costs of running a state, which in turn should allow the government to lower the tax burden needed to maintain internal order. Those savings can go to enhance both the Greek standard of living and to reduce the foreign debt. Second, deregulation increases overall output, so there is again more wealth available for debt repayment, current consumption, and the future investment that is sorely needed to return Greece to prosperity. The simple point here is that the only way to avoid the endless cycle of first incurring and then forgiving debt is to create wealth through deregulation and lower taxes.
But Greece—and the European Union—face a major roadblock. The ruling party Syriza is left-wing. Like the progressives in the United States, its members think that the way to create wealth is to support unions, to impose higher minimum wages, and to stifle various forms of competition. That orthodoxy runs throughout all of Europe. So long as the creditor nations of Europe cling to their own allusions that the full panoply of worker protections is an essential condition for both growth and for social justice, the entire enterprise is doomed. The so-called growth measures will just double down on the same failed interventionist polices that got the European Union into the current mess.
No one wants Greece to leave or be expelled from the European Union. That scenario will lead to a rapid devaluation of the new Greek Drachma, to a precipitous fall in living standards in Greece, and to major political distress that will give resurgent Marxist forces yet another rallying point for still further government regulation of the economy. It may be too much to expect Syriza to understand that its long-term success depends less on debt forgiveness than on fundamental structural reform. Marxist habits die hard. But hopefully Greece’s leaders will soon come around to this iron law of economics: you cannot redistribute what you do not produce.
*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.