It is surely clear to all sides by now – if rarely admitted – that Greece will never fully repay its bailout loans. The current approach requires Greece to run a large and protracted budget surplus to satisfy its creditors’ demands. This will force it to drain itself of demand for a generation or more to transfer to other countries huge amounts of what the Greek people produce.

History and economic principles teach us that trying to enforce such reparations-style logic on a heavily damaged economy will only serve to destroy it and harm the intended recipients too. It is time to end the pretence, and for Greek sovereign debt write-downs to become the central carrot for motivating growth-enhancing reforms in Greece.

For sure, Greece was at fault in joining the euro with the ratio of its sovereign debt to its GDP at over 100%, but its punishment is way beyond anything justified by this. Indeed, perhaps half the debt burden of Greece today is the result of the design faults of the euro.



After joining the single currency, Greece was flooded with super-cheap credit. Germany’s balance of payments surpluses ballooned from about €50bn when the euro was launched, to about €200bn in 2007, and these were recycled by enthusiastic banks as huge capital flows to the periphery of Europe. Germany built up a huge stock of claims against countries such as Greece, on which it was bound to lose one day. The only unknowns were the timing and how messy things would get.



When all those capital flows went into reverse, Greece, because of the euro, could no longer print its own money, nor devalue its currency to boost its exports, nor cut its interest rates, nor launch its own policy of quantitative easing, nor generate higher inflation to reduce the real value of its debt.

Many other countries shifted the burdens of their failed banks on to their governments’ balance sheets. In Greece, this would have increased the dangers of a sovereign default, and so Germany, the UK, the eurozone, and others, got their own banks indirectly bailed out through a loan-based “bailout” of Greece, dumping the problems onto the ECB and the IMF, as a gigantic IOU for the people of Greece.

A temporary increase in government deficits in a depression is entirely natural. For Greece, locked within the euro, such an increase heightened the risk of default, which pushed Greek borrowing costs higher, which made the ratio of its government debt to GDP rise even further. Preventing such destructive feedback-loops needed a mechanism for fiscal transfers within the eurozone towards member states facing big negative shocks or taking on the financial burdens of their banks.



Instead, Greece has been made to devalue internally. However, starving the country of domestic demand, and introducing massive economic uncertainty, has only served to depress both public and private sector investment there. It has devastated huge swaths of productive human capital (think of what 25% unemployment and over 50% youth unemployment do to the growth and tax-raising prospects of an economy). It has generated even higher ratios of sovereign debt to GDP, and it has further stoked deflation within Greece and the eurozone as a whole.



At first, the German people welcomed the artificial upside of the euro, and passed the systemic risk consequences on to countries such as Greece. Now, as the prospects for Greece worsen and the euro becomes more depressed, Germany’s exports receive a boost, and Germans become even less sympathetic. Meanwhile, all those panic-driven flows of capital flooding back into Germany have pushed 10-year German bond rates from about 3% in early 2011 to nearly zero today, easing Germany’s own budget problems. No wonder its politicians have been disinclined to spell out the optimal loss-mitigation strategy for Germany and the eurozone.



The stark reality is that Greece’s creditors must choose between two unpalatable scenarios. One is that Greece will leave the euro and default on its euro-denominated debt, its creditors will not get repaid anyway, and costly speculative pressures will mount on Portugal, Spain and Italy, while Greece itself will become more unstable politically and economically. The alternative is that Greece will stay, and its creditors will have to allow some further write-down on Greek debt. The latter scenario is surely the less painful.



Reforms in Greece need to go hand in hand with debt write-downs – not because of any special virtues of Greece, but because the logic of the euro makes it the only sane way out. Those who led the country into its mess are largely discredited within Greece. It has made huge progress in shifting its primary fiscal balance (i.e. before interest) and its structural fiscal deficit towards surplus. Further reforms now need growth, and this will only happen if economic bygones are treated as bygones.

•Andrew Farlow is research fellow in economics at Oriel College, Oxford, and author of, among others, Crash and Beyond: Causes and Consequences of the Global Financial Crisis (OUP, 2013)