This post is a special members-length weekly that I am making public because it is a continuation of the ideas for a Greek exit for the euro zone that I published on Friday. This post, however, also incorporates specifics that Marshall Auerback has laid out in a separate post and demonstrates why exit is the likely option.
Now, the Greek exit scenario I outlined on Friday is identical to the one I proposed in November for Italy when serious policy makers were toying with the idea of letting Italy enter a Greek-style death spiral. In Italy’s case, the country is too big to fail. Anyone who has tried running through Italian default scenarios understands immediately that Italian default equals a global Depression. This is why questioning Italy’s solvency leads inevitably to monetisation. The ECB has now stepped in and monetised the debt and will continue to do so.
Before we continue to Greece, I do want to flag something about the Italian situation that I wrote when explaining the monetisation route we are on in November.
Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.
As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.
That last bolded sentence is the key one. It tells you that Italy’s is a question not just of liquidity but solvency as well. For the time being, the solvency issue has been laid to rest by the ECB’s intervention. However, the euro zone is on a very pro-cyclical fiscal course. And this decreases GDP without any obvious growth offset, meaning that deficits will continue and Italy’s debt burden will grow under the current EU policy framework. It is highly likely that the solvency question for Italy will again become acute very soon.
It was refreshing to see Wolfgang Münchau reach similar conclusions in his recent piece in the Financial Times. He writes:
for argument’s sake, let us assume that Mr Samaras will stick to the programme and that a debt trap can be avoided. Everything works as officially planned. Would that be the end of the Greek crisis? In that case the Greek debt-to-GDP ratio would fall from over 160 per cent today to about 120 per cent of GDP by the end of the decade.
But this will still be far too much. We should remember that 120 per cent is a political number that lacks economic justification. It is no coincidence that this happens to be the current Italian debt-to-GDP ratio. If one admitted that 120 per cent was not sustainable for Greece, one might create a presumption that the same was true for Italy.
However, Wolfgang’s conclusion from this is the same as mine: Greece and Italy are different. Italy is a country with a primary surplus and a dynamic export base. It has a real shot at reducing its government debt levels in a less pro-cyclical fiscal environment. On the other hand, Greece not only lacks basic economic infrastructure on things like taxation to raise the revenue that would reduce the debt quickly, unlike Italy, Greece has been running a primary budget deficit across the business cycle. It is clear to everyone then that cutting expenditure and raising revenue poses a real challenge that Greece cannot meet. In Greece’s case 120% debt to GDP is still too high. Wolfgang concludes that a cut to 60% of GDP in the case of Greece (and Portugal) is the only way to give them a fighting chance. He says do it now because waiting two years would be "ruinous" as the riot scenes in Greece right now make clear.
Even so, Greece will have to exit the euro zone. Here’s why:
The Maastricht Treaty and the Lisbon Treaty clearly state that the goal is to “ensure closer coordination of economic policies and sustained convergence of the economic performances of the Member States”. This convergence has not come to pass and so now we are in a major crisis. It is becoming increasingly clear that convergence will never happen. The euro zone is unworkable. It needs tighter fiscal integration to succeed and it can’t have that unless it gets convergence. The Europeans are starting to recognize this and so breakup is now inevitable.
Unless you have true fiscal integration and convergence, Greece will continue to run current account and budget deficits even after the initial cut is made. So the problems we see now are endemic and they will re-occur. Marshall Auerback gets at why in a post at New Economic Perspectives on why "A Default is a Better Outcome Than the Deal on Offer."
Greece is a hopelessly uncompetitive economy that probably shouldn’t be in the euro zone. But can you surgically detach Greece if it defaults, without some sort of impact on the entire euro payments system?
And what will the impact be on Greece itself? The country currently runs a primary budget deficit (excluding interest payments on debt) of around 5% of GDP. Were it to default, Athens would be forced to go cold turkey ("cold Greece"?) until the primary fiscal deficit (now around 5% of GDP) is balanced. Maybe the government could suspend all military expenditures as a first pass? At the very least, they can stop buying German military equipment!
No question, that under a default, a lot of public sector employees will be sacked, pensions will be at risk, and unemployment will almost certainly go higher. But that is certainly going to occur under the deal now being struck.
Convergence between eastern and western Germany took twenty years after true fiscal and political integration and trillions of dollars in investment and solidarity taxes. That’s the kind of hard slog and commitment we are talking about here. Politically, this won’t happen. So, plans for Greece to exit will become the default scenario.
Marshall writes what the benefits of that exit would be:
Were the country to revert to the drachma, however, they would likely be left with a substantially weaker currency, which could ultimately provide the country with the wherewithal to compete in the global economy. With a super-cheap exchange rate, Greece could become a Mecca for retirement homes, research hospitals, trans-European liberal arts colleges, and maybe low-overhead software startups. Plus, a permanent home for the Olympics. It could live happily ever after, as Florida does, on the pension income of the elderly and the beer money of the young.
This would be the source of the foreign transfers that the private banking sector won’t make anymore. In Greece’s case that credit went to the public sector and a lot of it built useful infrastructure, so it’s not a waste, but the first step is surely to cancel the debts and stop the illusion that they can be paid. And it would end the "death by 1000 cuts" currently being imposed on the Troika, which will serve no useful economic, political or social purpose.
Of course, there will be a slew of defaults and an endless series of court cases, litigation, etc., much as there was when Argentina defaulted in 2001. But it would force the issue of debt restructuring on the table in a meaningful way and at least provide Greece with light at the end of the tunnel.
Now, the problem is getting from here to there. Likely this will mean state coercion to drive out other media of exchange, to prevent inflation spiralling out of control, and to minimise capital flight. Unfortunately, you can’t get from here to there without these factors. If someone can give me a plausible scenario that doesn’t involve capital controls, bank account conversions and so on, I’m all ears.
I outlined my seven-step Italian framework from November for Greece on Friday. This does not consider the bank solvency question, which is another separate issue:
- Plan. The Greek government can plan for a redenomination into New Drachma in secret that takes advantage of the Greek law jurisdiction over their sovereign debt obligations.
- Law. “Euroization” would remain in place and the euro would continue as the currency of physical payment. However, New Drachma would become the national currency.
- Taxes. The government would announce that henceforth it will tax exclusively in New Drachma. All municipal governments would be required by law to tax in New Drachma.
- Banks. The Greek government would (coercively) convert all euro bank accounts legally into New Drachma. The systems would process as if it were euros because of the fixed peg, but legally the money would be New Drachma. This would make the Greek economy “euroized” but make the banking system redenominated into New Drachma.
- Retail. Retailers, all sellers of Greek goods, would then be forced to return to the double accounting treatment of pre-2002 whereby they denominate all transactions in both Drachma and Euros. Paper money would be euros. The electronic money would legally be New Drachma, even while the systems said euro.
- Float. On day one, immediately after redominating, the Greek government would drop the New Drachma exchange rate peg and float.
- Physical currency. New Drachma would be printed by the Bank of Greece and introduced to replace euros.
Here’s why this proposal works: The forcible conversion of government bonds into New Drachma means at once that the government no longer has any default risk since all IOUs are in local currency which it could manufacture if necessary. The risk then becomes currency risk. As I wrote in Bond vigilantes and the currency relief valve:
So the currency gives way, not interest rates. And to the degree that interest rates would increase, the central bank can print. The currency revulsion question then is always currency depreciation, inflation and even hyperinflation (when and under what preconditions) not interest rate spikes.
The point then is to get the benefits of a floating currency but to mitigate inflation risks by instantly giving demand to the new Drachma by making all government taxes payable in Drachma. The New Drachma will be heavily depreciated and that will cause the price level to rise, which amounts to an instantaneous lowering of living standards. But if the currency can be stabilised then after this initial period, the devaluation doesn’t have to be inflationary. Iceland’s 2009 devaluation and capital controls is a guide here. In Argentina’s default, state coercion in the form of re-denominating non-Peso bank deposits helped. I remember being aghast at this theft at the time. But the reality is the state will want to drive out the use of all other media of exchange and so will be forced to do this with New Drachma as well. And forcing retail transactions into New Drachma entrenches the currency as a medium of exchange. Clearly Marshall’s comments about getting better tax enforcement, by for instance taxing property instead of income, are key to making demand for New Drachma enough for the scheme to be successful.
To ensure some sort of viability of the drachma, the Greek government would have to find a more credible means of ensuring tax compliance. Most Greeks with money have presumably already moved it beyond the reach of the Greek banking system, so that savings would not be wiped out. As the tide of repossessions begins, many of these oligarchs would likely start to buy back the Greek assets on the cheap, as it is doubtful that the euro banks will want anything to with them.
Beyond that, it would be important for Athens to establish a new tax system that minimises tax evasion, so as to create demand for the new drachma immediately, and mitigate the formation of an extensive parallel transactions currency. After all, it is possible that many Greeks might prefer to use the existing stock of euros in the country and there is very little the EU authorities could do to stop this (much as the US government could not prevent Panama from dollarising its economy). But in order to establish a long-lasting demand for drachmas, two things would have to happen:
- The Greek government would announce that it will begin taxing exclusively in the new currency.
- The Greek government would announce that it will make all payments in the new currency.
Given the country’s history of tax evasion on income tax, a national real estate tax would likely work better than a new income tax.
(See here for more details:)
Once all of these issues are taken care of, the demand for the currency should be sufficient and at that point all that would be left is to print the new currency.
The fact that Willem Buiter’s proposal at Citigroup is very similar to mine tells you that this is the kind of outline other euro watchers are going to come up with. His points on EU exit and capital flight are key. I agree with all of his points except the one on a currency peg. Greece is not competitive in a currency union with Germany and would suffer the problems with a peg.
Business Insider outlines Buiter this way:
- Grexit will only happen when Greece publicly flouts troika recommendations and has no chance of receiving aid.
- Greece will pass a currency law setting exchange rates and limiting those who can file suits against the Greek government in foreign courts.
- It will simultaneously impose strict capital controls to prevent capital flight.
- Greece could pursue a currency peg, but probably not for a few years.
- Greece might also decide to exit the European Union, but probably wouldn’t if it defaulted because the ECB wouldn’t give it money.A credit event would occur, provoking CDS payouts, though its timing could vary.
- The New Drachma would sharply devalue.
- The value of the euro would probably decline, probably by about 10%.
- While foreign banks and financial entities will take losses in the event of a Grexit, they will be manageable.
- Given Greece’s limited size, it’s likely to have little impact on trade, even to its closest trading partners.
- EU leaders would likely take strong action to prevent contagion.
- However, this support is not likely to be unconditional or unlimited.
- Regardless, there are lots of options left to maintain stability.
In conclusion, a Greek exit from the euro zone would be traumatic and the potential for serious policy errors exist. However, Greece’s fiscal path is not sustainable as part of a currency union dedicated to a strong currency and immediate fiscal balance, even with a haircut that takes government debt to GDP down to 120%. Moreover, even with Greece fulfilling the Maastricht criteria after a haircut down to 60% government debt to GDP that includes ECB (public sector) involvement, the lack of euro zone convergence means these problems will arise again. Greece is simply not competitive as part of a currency union with Germany – and it never will be. That means almost permanent fiscal transfers and a loss of Greek fiscal sovereignty. The political will necessary to support this solution does not exist. And so Greece will exit the euro zone. I have just outlined what I think is a good way for this exit to be executed.