Contested Sovereignty The case of Greece

Abstract: This thesis examines the issue of political versus economic incentives to default, with regard to the present Greece debt crisis. It is hypothesized that when a country has strong political incentives to not default on its debt it will choose not to do so, despite such a course being advantageous according to economic rationale. To assess this issue, a sovereign default model is calibrated to match the economy of Greece. The model mimics the core movements of the data quite well, with exception of spreads and debt-to-output-ratio, and it predicts a default for Greece every 312.5 years. The sensitivity analysis illuminates a high sensitivity to the assumption of a highly patient borrower, resulting in low spreads and a low debt-to-output ratio. Since the early thirties no Western European country has defaulted on its debt. It has been regarded as a rather remote phenomenon occurring in distant developing countries, or in socialist/post-socialist republics.1 This track record has however been challenged in the aftermath of the financial crisis erupting in 2007, starting with socialisation of several banks in various countries. The most extreme example of a bank bailout had been in Iceland, which has been subject to speculations as to whether or not the country will default on at least parts of its debt. Iceland has been followed by a debt crisis in several EMU countries, most notably Greece, Spain and Portugal. The economic crisis, and potential implications for EMU countries, has spilled over from being a purely economic matter to also encompass a political crisis. Despite several bailouts from the other member countries and the IMF, the Greek crisis still lingers on. The need for a Greek haircut and political reforms within the EU, in order to avoid a Greek default, seems to become even more urgent by the day.2 One might thus ask whether or not Greece should already have defaulted on her debt, instead of continuing to service it and implement austerity packages rendering social unrest. There must certainly be some important incentives that make a default an implausible outcome. That constitutes the basis for this thesis, to test whether or not Greece indeed should have defaulted and, if so, what other credible motives it had for not doing so could be. The nature of sovereign debt differs greatly from common commercial debt, as it is not enforceable. As pointed out by Obstfeldt and Rogoff (1996), a sovereign default is more related to a sovereign’s willingness rather than ability to service its debts. There might be several situations where a government might be able, but not willing, for many reasons, to service their debts. Consistent with the theory that it is a question of will rather than ability, one could argue that harsh political implications associated with a default might deter such actions. Such logic might particularly apply to the case of Greece, as it is a minor country in the EU/EMU. Whilst one cannot be explicitly certain about the nature of political consequences, the mere existence of a worst-case scenario could work as a strong incentive to avoid default.3 However, one must first lay the foundation as to whether it is in the economic interest of the government to default. For this purpose the model presented in Arellano (2008) is calibrated to match the Greek business cycle, and used to assess whether or not it would have been beneficial for Greece to default on its debt. Assuming that the Greek sovereign places a high valuation of future consumption, the results indicate that the government exposed to these conditions would find it profitable to indeed default prior to Q12011 only in 10% of the cases. Under this assumption the model is adequately able to mimic the core movements of data, except for underestimating spreads and debt holdings. A sensitivity analysis reveals that the whether or not default would have been a more economically plausible route depends mostly on how future consumption is valued compared to present day consumption. The thesis is structured as follows: at first the earlier research on sovereign default incentives and the founding hypothesis is outlined. Thereafter the sovereign debt model of Arellano (2008) is described accompanied by a non-technical summary at the end. In addition this section includes the European integration theory that constitutes the basic political rationale. Potential issues with underlying theory and model application are scrutinized in section III, entitled Methodology. Subsequently the data movement, the empirical results from the simulations and the sensitivity analysis is shown. The thesis ends with some concluding remarks.