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As I ‘ve highlighted many times in the past, the level of future long-run primary surpluses for Greece plays a major role in the debt sustainability scenarios. The major difference between the IMF and Euro institutions projections is identified in the primary surplus assumptions. The IMF projection for a 1.5% surplus makes debt restructuring necessary while the European institutions assume much higher primary balances which make debt sustainability more favourable.

IMF vs Euro Institutions Greek DSA

A recent ESM paper on Greek debt reveals the importance of these projections. If Greece achieves 3.5% primary surplus until 2032 and 3% until 2038 no debt restructuring is required as long as economic growth is 1.3%. On the other hand, the IMF scenario of 1% economic growth and a primary surplus of 1.5% after 2022 makes Greek debt explosive.

European institutions try to make the case that episodes of large and sustained primary surpluses are not uncommon in European modern history. The ECB especially highlights the cases of Finland and Denmark as well as other countries:

The European Central Bank says such long periods of high surplus are not unprecedented: Finland, for example, had a primary surplus of 5.7 percent over 11 years in 1998-2008 and Denmark 5.3 percent over 26 years in 1983-2008.


ECB - Selected Episodes of large and sustained primary surpluses in Europe

My comments are twofold. First, the average primary surplus figure is not always equal to the year-by-year primary balance. Denmark achieved a primary surplus equal or higher than 5.3% in only 5 years during the 1983 – 2008 period. Actually, the primary surplus was at least 3.5% during 9 of the total of 26 years.

Yet the most important element that is not highlighted in the above cases is the fact that large primary surpluses were achieved in the context of equal or (mostly) higher current account surpluses. This is highly important since it allows the domestic private sector to achieve a positive net asset position even when the public sector is in surplus. As a result, economic growth is not threatened by the public sector and the private sector maintains a healthy balance sheet.

To illustrate the above I ‘ve «corrected» the primary surplus by subtracting the current account surplus. I ‘ve also deliberately set the vertical axis maximum to 3.5% which is the surplus requested from Greece to illustrate the fact that it is almost never achieved.

corrected primary balance for current account - selected high surplus episodes.jpg

On the contrary, of the total of 60 years in the above episodes, 26 had a negative corrected primary surplus while it was lower than 1.5% in 40 years illustrating the fact that the IMF assumption of a 1.5% surplus is not unreasonable.

Since the Greek cyclically adjusted current account is highly negative it is clear that the assumption of high primary surpluses which will be maintained for decades is almost without precedence in the context of the private sector balance. Assuming a 3% nominal growth rate (based on the IMF assumption of 1% growth), a 10 year 3.5% primary surplus is equal to a 30% GDP transfer from the domestic private sector while a 20 year 3.5% surplus is equal to 52% GDP transfer which will not be counterweighted by a current account surplus.

In my view, the European institutions continue to make assumptions consistent with avoiding explicit costs for Greece’s creditors but inconsistent with economic reality and sectoral balances.

So it is more than clear that European creditors of Greece are continuing to demand long-term primary surpluses around 3.5% of GDP. One has to ask: What’s so special about this number? Why can’t it be lowered a bit and give Greece more breathing space?

The answer is quite simple:

2% interest rate x 180% debt to GDP = 3.5% of GDP/year

The 3.5% primary surplus target is the one consistent with maintaining the debt-to-GDP ratio stable when the nominal GDP growth rate is zero. This means that Greece can  withstand shocks to its nominal growth rate (negative real GDP growth or a deflationary shock) and still manage to keep its debt ratio stable. Obviously, as long as it manages to achieve positive nominal growth its debt ratio will decline each year while privatization receipts will lower debt even quicker.

From a slightly different point of view, the 3.5% target provides insurance to European creditors that any short-term failures of the Greek program will not lead to an increase of the debt ratio, only to a flatter decline path. The risk of the Greek program not achieving its ambitious targets is pushed on the back of Greece while its creditors can keep the upside of any positive shocks that will improve debt sustainability.

Yet again one observes that the Greek issue is mostly a political rather than an economic issue. It relates to the question of who provides insurance regarding the program targets. Since European creditors appear unwilling to provide such insurance my feeling is that agreeing on a lower target will prove substantially difficult, especially in the current political climate across Europe.