Sunday, February 12, 2012

Greece: the end-game nears

It is not surprising there are now riots in Athens.  It is now all too clear that even though Greek levels of debt are not yet at Japanese levels, Germany doesn't want Greece in the euro anymore.  If Greece doesn't leave the euro then not only will all political parties have to agree to institute the measures insisted on by the other euro area finance ministers, but also they will have to endure economic misery in the form of a depression for at least the next 5 years, if not longer.

As we say in economics, you have to evaluate the net benefits from doing this or from leaving the euro, because both are not going to be pleasant for Greece, and the possible choices facing Greece have potential ramifications for the rest of the world.  So let's look at this in terms of the choices facing Greece and then what the implications will be on the EU and on the rest of the world.

Scenario 1: Stay in the euro and Greek politicians behave. 

Greece has entered it's 5th year of recession, and unemployment is now at over 20%, and will undoubtedly approach Great depression levels of 25% this year if the austerity programme that the EU insists must be implemented goes ahead.  Now €130bn sounds like a lot of money, but in the context of the whole EU economy it is a relatively small amount.  The point here is that the Northern Europeans are tired of this never ending Greek bailout saga and they want this to be the last bailout so they are really tightening the screws. 

Staying in the euro would probably be the best solution for the rest of Europe and the rest of the world as long as this really is the last bailout and Greece accepts that it has to remain in depression for another 5 years.  Doing this though would likely see the Greek social order implode. As the Archbishop of Athens put it: "Homelessness and even hunger — phenomena seen during (World War Two) — have reached nightmare proportions. Patience among Greeks is running out, giving way to a sense of anger, and the danger of a social explosion cannot be ignored any longer. The medicine we are taking has proved fatal for the nation. More painful, and more unjust measures are now set to follow along the same, hopeless course."

So what's best for Europe and the rest of the world is probably worst for Greece, as it doesn't default, has it's hands tied and it's population have to endure more years of misery.
Scenario 2: Stay in the euro and Greek politicians misbehave.
This option essentially kicks the can down the road yet again, but still imposes misery on Greece and at the same time means that Greece will be back again for a further bailout in less than a year.  The Germans were right to suggest that someone from the Commission should be in Athens overseeing the Greek budget as historically it has been one of the most untrustworthy economic documents in terms of statistical reliability.  And the fact that the Greeks were affronted and said no means that if they take the bailout money this time around the rest of the EU has very little control in terms of what actually happens with the money and over the setting of future budgets.  This is despite the letters that have been signed by the current leaders of the political parties.  Add to that that political leaders are changing all the time in Greece right now, and you can see that the letters are only a commitment of one particular political leader, with the whole austerity package therefore having an automatic "loosening bias" as political leaders change through time.  The other point here is that politicians like to get re-elected - why would you vote for someone who is honestly going to impose austerity on you?  If I were a Greek I would much rather vote for a politician that says all the right things with a nod and a wink so that things are not nearly as bad as you expect. 
This scenario is bad, but not quite as bad as scenario 1 for Greece - I would expect that the economic outlook is not quite as bad for Greece in the short term, but of course will likely lead to another crisis in the future and therefore we could be back at this crossroads again.  It is definitely not good for the rest of Europe, and likely not so wonderful for the rest of the world either.  The reason for this is that kicking the can down the road clearly involves a future decision about whether to kick Greece out of the euro because the next time around there will likely be a disorderly default, and then the rest of the EU will not want the contagion connected with this and will want Greece out of the euro.  The trouble is there is nothing in the Maastricht Treaties that specifies under what circumstances a country is forced to leave the euro.  This would be a real headache for the rest of the EU and would hence threaten the whole "harmony" within the euro and the consensus decision-making at the ECB.  Spain, Portugal, Ireland and Belgium would obviously all be watching the events that unfold around this scenario very carefully.

Scenario 3: Greece leaves the euro and returns to the drachma
This is, I now think, the most likely scenario. The immediate effect on Greece would be cataclysmic as money flows out of the country.  Exactly what happened in Argentina when they left the currency board will likely happen in Greece.  Anyone holding euros in a Greek bank would see these frozen and then converted into Drachmas at the official exchange rate that Greece entered the euro at, and then once the drachma is floated the accounts are unfrozen.  That means that savings are now converted into drachmas and then the drachma will obviously collapse against the euro meaning that savings will immediately be devalued by a huge amount making everyone a lot poorer in international terms and causing a severe bout of inflation as all imports are priced in non-drachma terms.  Of course the way to avoid this is to get your money out of the country now, so I'm sure there are huge capital flows happening right now to safeguard savings and other assets against this particular scenario.

The immediate effect would be horrible for Greece, as it was in Argentina, but the pain in these "almost instantaneous" adjustments is usually short-lived, and once the drachma gets into equilibrium with other currencies again, things usually quickly improve.  Obviously there is absolutely no way that Greece could repay any loans made in euros, so a disorderly default is inevitable. 

The pain here is on the Greeks, as well as private creditors in the rest of the euro area and on the credibility of the euro area, as it has it's first casualty as a country voluntarily leaves the euro.  Note that Greece would not be leaving the EU, and it's exports should improve dramatically as the national currency sinks to a new equilibrium level, and it would lead to a surge in inflation and therefore an automatic adjustment to real wages.  The credibility of the euro and the EU officials here would be badly hit, as would private banks that hold Greek debt.  Also if Greece does come out of the euro and quickly turns things around other countries might also be tempted to do the same, which could prompt a partial unravelling of the euro as well.  The effects on the rest of the world would be negligible, but could impact the banking sector as a domino effect occurs through European banks.

Scenario 3: Greece returns to the drachma and sets up a currency board

This is a variation on scenario 4 above.  Here though Greece leaves the euro area but reintroduces the drachma and allows the drachma to circulate alongside the euro at fixed rates, which presumably it would determine in such a way to take into account inflation differentials with the rest of the euro area over the past 9 years, and then some.  This way some of the pain for the Greek public associated with scenario 4 could be overcome, but at the same time the Greek government would likely have to default on its debt.  This would be an attempt at an "orderly exit" from the euro rather than the usual "disorderly exit" that happens when fixed exchange rate regimes collapse.  The big question here is how would Greece come up with the euro assets to fund the currency board?  Part of that might lie in persuading creditors to agree to a swap of a Greek euro denominated debt into Greek drachma debt and favorable rates and then use this Greek euro debt as an asset to fund the currency board.  This would be akin to asking investors to take a stake in the "new" Greece, in exchange for giving up old "soon to be worthless" assets.

I think this is a viable option for Greece, and probably is the best option in terms of Greece leaving the euro from an economics perpective.  Of course whether Greek politicians have the nouse or the will to think something like this through is another matter.  We shall see.

Featured Post

Free Trade on Trial - What are the Lessons for Economists?

This election season in the US there has been an extraordinary and disturbing trend at work: vilifying free trade as a "job kille...

Popular Posts

Search This Blog