Wednesday, March 18, 2015

Grexit, from Threat to Promise

Here are the overriding facts that are unlikely to change without a change in policy:

1. Greece is in the grips of an economic and humanitarian crisis.  In fact, unless there is a substantial change in course, it runs the risk of becoming a failed state altogether.

2. Greek sovereign debt is not payable.  Its society will collapse first.

3. There does not exist the political will in Europe for a transfer union that mutualizes the obligations and needs of Greece on a permanent basis.  This is in contrast, for instance, to the United States, in which most sovereign debt is mutualized and interstate transfers occur on a routine basis.  A transfer union might be a first-best solution in Europe, but it is politically infeasible.

4. Under current circumstances, Grexit would be experienced in Greece, and possibly through much of Europe, as a catastrophe.  A hurriedly introduced drachma would be unanchored, and the redenomination of contracts would be chaotic and disruptive of ordinary business.  Greek savings would either flee or be largely wiped out, with dangerous political consequences.

5. Nevertheless, Greece was a poor candidate to enter the eurozone when it did and is a poor candidate to remain in the zone today.  Above all, it lacks a sufficiently large, diversified and productive export sector to permit growth under a fixed exchange rate without the accumulation of unsustainable current account imbalances.

6. Greece is a small country from an economic perspective, and its political-economic challenges are unique.  Properly managed, Grexit does not need to lead to similar policies for larger countries, like Spain and Italy, whose imbalances are not structural in Greece’s sense.

7. Finally, the political evolution of the antagonism between Greece and the creditor countries is pernicious.  The nationalist rhetoric of victimization and resentment, wherever it occurs, is a proven threat to peace and international cooperation.  This alone should be reason enough to change course.

At present Grexit exists as a threat wielded by both sides to extract concessions from the other.  It is a threat to the extent it would be catastrophic, either for Greece in the form of economic chaos or for Europe in the form of contagion.  Nevertheless, properly prepared, Grexit could be a mutually beneficial solution.

What would proper preparation look like?  Here is the sketch of a plan:

First, Grexit would be proposed as one element in a comprehensive solution whose political premise is substantial generosity on the part of the creditor countries with the understanding that this is strictly a one-time event.

Second, as a precondition for Grexit, the existing sovereign debt of Greece would be largely written off, with a residual obligation (under 50% of GDP) clearly consistent with favorable growth prospects.  This may require Europe to assume some degree of obligation for Greece’s debts to the IMF.

Third, the ECB would provide temporary euro reserves to the Bank of Greece in order to support a stable transition back to the drachma.  This could take the form of a swap line which would be resolved and terminated by some target date several years after Greece’s exit from the euro.

Fourth, the mandatory redenomination of contracts and financial assets whose payment streams would be in drachmas would be permitted to occur over a suitable time frame, such as a year.  In other words, just as with eurozone accession, eurozone exit would involve a period of dual currencies with strict parity in order to facilitate orderly redenomination.  The commitment of the ECB to support the drachma well beyond the period of redenomination would underwrite this process.

The end result would be an economically sovereign Greece and a eurozone no longer obligated to finance it.  Both sides would benefit from better conditions for economic growth and reduced political stress.  In fact, it is probable that the large-scale economic restructuring needed in Greece can be accomplished only under circumstances of fundamental sovereignty and freedom that allow experiment with deep reforms.

Such a Grexit should be viewed as a solution incorporating goodwill on all sides, whose goal is progress and not punishment.  It would not be accompanied by expulsion from the EU or any other retaliatory measure.  After a suitable period of time, Greece could reapply for eurozone membership if it chooses without prejudice—either against or for accession.

UPDATE: I have left out perhaps the most difficult aspect of a gracefully managed Grexit, the issuance of new Greek sovereign debt during the dual currency period.  The more such debt is issued, the greater is the ECB’s de facto commitment to the drachma.  The typical eurozone solution would be to impose an upper bound on Greek deficits over the period, probably adhering to the bright line of the Stability and Growth (sic) Pact, in exchange for drachma support.  This would not be ideal, but under the circumstances it is probably necessary for selling the deal.  And Greece would always have the option of foregoing the support if it had confidence in its monetary and fiscal space.


JW Mason said...

I agree with most of this. A couple caveats:

I think we need to think more critically about point 4. In particular, it's important to realize that "Grexit" is not an all-or-nothing option. There is no technical reason why the Bank of Greece cannot maintain the interbank payment system among Greek banks, by allowing settlement between them using its own liabilities. In this situation, Greek bank euro-denominated bank deposits would continue function as means of payment within Greece. Capital controls would be imposed automatically in this scenario, assuming that banks elsewhere in Europe refused to accept BoG liabilities for interbank settlement. The problem of paper currency is easily addressed through devices like cashier's checks, money orders, etc. There is no need for Greece to formally introduce a new currency or for any contracts to be redenominated.

I think a great deal of confusion on this point is created by people's mental habit of thinking of money as currency, when in modern economies money is bank deposits.

Second on point 5, the emphasis on fixed exchange rate suggests a (to me) undue confidence that floating exchange rates prevent balance of payments constraints from binding. I think there are lots of theoretical and empirical grounds for thinking that this is not the case -- that there is no reason to expect a floating exchange rate to move in such a way as to allow Greece to achieve higher growth while maintaining current account balance. The problem is free trade and capital mobility, not fixed exchange rates.

Peter Dorman said...

First point: I will have to think more about this. At first blush, I am skeptical that parallel accounts can be maintained without policy-relevant spillovers. This looks too much to me like a system of multiple exchange rates, especially if differential risk premia are included.

Second point: I agree that exchange rate flexibility is not sufficient to dispel current account constraints, and I've posted on this many times over the years. Nevertheless the constraints are less onerous with flexible xrates than without them. This is simply the argument that, in the absence of other border-dissolving institutions, the euro is a new gold standard. Getting off gold may not be sufficient, but it's definitely necessary.

Specifically in the case of Greece, there will need to be some sort of protection/support for new export sector investments, and that will be easier to do if the drachma can be depressed somewhat.

JW Mason said...

Sure, there will be spillovers. But we are comparing it to an alternative that, as you rightly say, would be catastrophic. I also think that the big things that the Greek government would have to do in this case -- impose capital controls and ration foreign exchange -- are things it probably needs to do anyway, to address the longer-term balance of payments issue.

On flexible exchange rates, frankly, I'm skeptical. I agree that the euro is a restored gold standard, but the gold standard was more than a system of fixed exchange rates. The critical constraint imposed by both the euro and the gold standard is the inability of governments to control domestic credit creation. I think the historical record of developing countries suggests that our null hypothesis should be that floating rates in themselves have zero effect in relaxing external constraints.

Peter Dorman said...

Hmmm. Your point #2 is an extreme version of structuralism. My reading of the development record is that this is difficult to defend, but we don't have to resolve this here. At least we've identified the issue. said...

Well, there is the Cyprus outcome where they issue their own "euros" only usable internally while still being officially part of the system, which I think is what Mason is talking about, although I am not quite sure.

There does seem to be a gradually increasing strain on Greece, with its 10-year bond drifting up from below 10% yield to more than 11% now and its stock market drifting downards, although neither of these as bad as back in January right after the election. But, I think we are still quite far from catastophic breakdown, and despite a lot of noisy rhetoric on both sides, there remains enormous political will to have Greece stay in the eurozone, if not only because under current law, Grexit from the eurozone will also mean Grexit frmo the EU, which is not at all popular in Greece.

So, I continue to think that the most likely outcome will be more muddling through, with both sides declaring victory with each muddle. Especially those on the right in the US were loudly proclaming before the recent four month punt that this would be it, and Greece would be tossed out, and the Syriza governmnet taken out and shot, or something like that. There was a punt, and both sides could claim gains. I still think this is most likely when the next round comes up.

JW Mason said...

Cyprus is a model in some ways, for sure.

The point I am trying and apparently failing to get across is this: No government "issues" euros, or dollars, etc. That isn't how money works. Euros ARE bank deposits. All the central banks has to do is to ensure that bank deposits can be used to make payments, by providing for system of settling interbank obligations.

Myrtle Blackwood said...

The new Greek finance minister describes the current Eurozone 'bailout' arrangements for Greece as 'ponzi austerity':

"..Ponzi austerity is the inverse of Ponzi growth. Whereas in standard Ponzi (growth) schemes the lure is the promise of a growing fund, in the case of Ponzi austerity the attraction to bankrupted participants is the promise of reducing their debt, so as to liberate them from insolvency, through a combination of ‘belt tightening’, austerity measures and new loans that provide the bankrupt with necessary funds for repaying maturing debts (e.g. bonds). As it is impossible to escape insolvency in this manner, Ponzi austerity schemes, just like Ponzi growth schemes, necessitate a constant influx of new capital to support the illusion that bankruptcy has been averted. But to attract this capital, the Ponzi austerity’s operators must do their utmost to maintain the façade of genuine debt reduction.

Ponzi austerity’s inventor: The Eurozone’s great and good..."

Source: PONZI AUSTERITY: A definition and an example
Posted on November 8, 2013 by yanisv

In other words, Varoufakis is saying that the Eurozone cannot save Greece from 'bankruptcy'. In which case Greece might be seen as having nothing to lose by exiting Eurozone arrangements.

The trouble is that Greece's economy, like that in many nations on earth, is very interdependent in structure with the global economy; whether Greece is in the Eurozone or not. This structural reality does not give Greece's government a lot of room to manoeuvre. I see radical changes ahead.

Peter said...


But the austerity did work from a certain perspective, in that Greece has a primary surplus now. This strenghtens their bargaining position.

I'd agree that it didn't work in that they suffered a humanitarian crisis and it's slow going. It's been five years - which is an eternity under a humanitarian crisis - and how much longer would it go? Ten or twenty years?

Plus it's possible the whole thing repeats itself with a boomish period followed by a long painful "recovery."

Myrtle Blackwood said...

Greece's, like the rest of the industrialised economies (in particular) need to restructure. Some of it has already begun, with 'peak child', sharply increasing use of solar and wind technologies, etc.

But this is also a paradigm shifting crisis. We need to go forward with the emphasis on provision of human and environmental needs, not on profit creation.

I don't think we'll have a 'recovery' in the conventional economic sense of the word.

Peter T said...

As a side issue:

JW Mason above: "I think a great deal of confusion on this point is created by people's mental habit of thinking of money as currency, when in modern economies money is bank deposits."

Money has always mostly been bank deposits: this is clear from the fairly complete record we have of the evolution of money. And bank deposits are debts, and the key question about any debt is 'can it be repaid?". An enormous amount of confusion, obfuscation and derangement would be avoided if this were acknowledged.

Unknown said...

Regarding "Side issue":
Agree with JW Mason and Peter T
Also, money creation via new loans and new demand deposits

Myrtle Blackwood said...

A good article, Peter.

I query your assertion that Italy and Spain do not have structural deficits, unless they've managed to overcome their reliance on energy imports?

Thornton Hall said...

Seems to me that if Germany and France are uninterested the U.S. could buy a couple of export markets cheap, not to mention military bases as Turkey and Israel become less reliable Mediterranean allies by the minute.