It took just a few months after the completion of the biggest-ever sovereign debt restructuring in history, known as PSI (Private Sector Involvement), for policymakers and others to see what the markets have been saying all along: that the Greek public debt has not become sustainable.

Unfortunately, most decision-makers in the European Union now appear to be leaning toward a writedown of Greek debt in public hands, which is hardly the optimum solution.

PSI turned out to be a big success as far as high investor participation and smooth execution was concerned, but it failed in the most critical test: To provide significant debt relief and convince the markets that the Greek public debt was sustainable, unleashing a series of positive reactions from investors and others that would contribute to the stabilization of the economy.

Debt relief should have amounted to more than 100 billion euros, or 50 percentage points of GDP, after the completion of PSI. This, however, did not happen for specific reasons: Greece is still running a primary budget deficit projected close to 1 percent or 2 billion euros this year. In addition, the so-called snowball effect emanating from the difference between the average nominal interest rate and GDP growth continuous to burden the debt-to-GDP ratio.

The same holds true for tens of billions of euros in official funds/bonds destined for the recapitalization of Greek banks and paying off state arrears. Also, intergovernmental bond holdings held by pension funds and others are not included in the general government debt calculation, making the debt reduction under PSI smaller. Social security funds saw their holdings of more than 24 billion euros cut by more than half in value under PSI.

So, PSI did not provide the kind of debt relief that the markets and others wanted to see in order to believe that Greece could, under some normal assumptions, significantly bring down its debt ratio from the start, and also to benefit from the lower average lending rate and the light redemption schedule in the years ahead due to the extension of maturities.

It is clear that the worse-than-projected performance of the Greek economy in 2012 and its likely underperformance next year necessitates changes to the sustainability analysis of the Greek public debt. The lack of satisfactory progress in the privatization program means the positive impact on the debt from this source may not fully materialize. Also, fiscal slippage cannot be ruled out for sure in 2013 and 2014 if the economy continues to shrink. The situation becomes more nebulous if one assumes a one- or two-year extension of the Greek economic adjustment program wanted by the new coalition government.

So, the goal of pushing the debt-to-GDP ratio down to 120 percent of GDP in 2020 from 165 percent in 2011 envisaged by the IMF is difficult to attain and will require additional debt relief, in order for the Greek debt to be deemed sustainable. There is already talk that the Greek bonds held by the ECB and other national central banks will have to be restructured to make it possible. Many had criticized the ECB for refusing to take part in PSI but now the issue is coming back since writing down bilateral EU loans to Greece is politically very sensitive. The ECB had refused to take part in PSI, arguing that it would amount to direct state funding, which is prohibited by its charter and runs contrary to the tradition of Bundesbank, the German central bank, after which it is modeled.

Assuming that the ECB’s Greek bond holdings amount to 45-50 billion euros, a 53.5 percent haircut along the lines of PSI, would have provided debt relief of 24-26.75 billion euros. This may be enough to bring the Greek debt ratio down to 120 percent of GDP by 2020 under the new more ominous assumptions about the economy -- privatizations etc. -- but we think it will still not be enough for the markets.

To change the game, policymakers must be willing to do more -- assuming Greece honors most of its commitments under the second financing package. It does not take a genius to see that this can happen without compromising the ECB’s mandate.

As others and we have suggested in the past, the ECB can transfer its Greek bonds to the EFSF or the new permanent mechanism, ESM, at the average price bought by the EU central banks, allegedly between 70 and 80 percent of the nominal value. This way the ECB will not lose money on its Greek bond holdings. Moreover, the EFSF or the ESM can extend a long-term loan to Greece at a reasonable interest rate that will be used to buy the same bonds from them at the same price or lower. This way the country will be able to cut its debt by cancelling the bonds of a higher nominal value.

Since this exercise will not be big enough to provide significant debt relief -- it would save just 10 billion on bonds with a nominal value of 50 billion euros, which undergo a 20 percent haircut -- the same entities could provide Greece with a bigger loan to engage in debt buyback or they could do it themselves and swap the savings to Greece. This is a market-friendly way to make the Greek debt sustainable in the eyes of the markets. Of course, Greece will also have to do its part by meeting the fiscal targets and modernizing its economy.

All-in-all, a market-friendly debt buyback at the current beaten-down prices of Greek bonds is the best way to cut the public debt significantly and create the conditions for a turnaround in the local economy with positive results for the eurozone. Whether political wrangling and myopia will again stand in the way remains to be seen. However, it looks as if this is the best way to get the ECB out of the difficult position of writing down its holdings, making the Greek debt sustainable and reducing the likelihood of contagion, with a visible improvement on risk bond premiums in the euro periphery.