John McHale has a recent thread on the probability of a Greek default. In this thread I want to consider a different but related question. Only some of the promised Greek bailout funds are intended for funding Greek government expenditures; the rest of the funds are intended to pay back outstanding Greek sovereign bonds. Conditional upon a Greek default, how should the bond-payback-earmarked Greek bailout funds be spent by the Eurozone? Let X denote the total sum of Eurozone bailout funds intended for Greece, Y the amount earmarked for Greek government expenditures, and Z the funds available to pay back Greek bondholders. Define a disorderly Greek default as one in which a private sector involvement (PSI) agreement is not in place or is inoperative. My question is:
In the event of a disorderly Greek default, how should the EU spend Z?
There is a historical precedent for massive wastage of taxpayer funds in analogous situations. Bulow and Rogoff call it the “buyback boondoggle.” The buyback boondoggle refers to the tendency of fiscally-distressed states to demonstrate their newfound fiscal discipline by handing over large quantities of taxpayer funds to outstanding bondholders, even when there is no fiscal benefit in doing so. In reality, the payment of funds to existing bondholders by states in fiscal distress can actually lower rather than raise the future borrowing prospects of the state (see the paper above and this related paper).