Greece needs to leave the euro: Part II

My response to a great article by Martin Wolf in the FT on 6/16/2015 which you can read here.

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Excellent article by Martin Wolf, but not really too revealing on what the options might be. 

Governments are responsible to their voters, not to the holders of the country's national debt.  When you look at that chart of real domestic demand at around 68 percent of where it was in 2008, you also understand that the Greek government needs to stick to it's guns this time. 

The sad thing is that these negotiations have not allowed any latitude for new measures, such as perhaps the conversion of some of the existing debt to consols, or the future sale of some Greek assets (Mykonos?) - they have almost exclusively focused on extracting further austerity measures from the Greek negotiators.

Given the lack of any imaginative initiatives on the part of the negoatiators, the unsuitability of Greece for belonging to the euro area (due to it not satisfying the optimal currency area critieria), as well as it not properly fulfilling the Maastricht criteria for joining the euro in the first place, the Greek government now needs to plan it's exit from the euro.

Despite Mr. Wolf's concerns about Grexit, I really don't think these specific circumstances apply to any other euro area member states, so the prospect of any contagion is minimal..

The really sad thing is that this whole Grexit thng has been kicked so far down the road as far as it has. The can is looking pretty crushed and deformed now, having been kicked so much - so now is the time to take the can off the road and put it in the garbage, or recycle it! 

Is the path to an OCA paved with wasted euros?

First off, apologies to my blog followers for not posting in a couple of months!  I have been through a very stressful time at University ( - a lot of politics!), plus I am organizing a workshop in EU economics at George Mason University on the Euro area in 2 weeks time, so time has been in short supply!

It is always dramatic to hear when someone says "Europe is at a fulcrum" as Jim Cramer did the other day in his excellent program Mad Money on CNBC - but this time (and boy there have been many times recently), I think this call is spot on.  The main problem is that things are beginning to spiral out of control, and from a variety of perspectives there is no political consensus on how to fix things.  But before we get into the nitty gritty details about what might happen and what will probably happen, let's take a step back from the "rolling crisis" in Europe and look at the whole situation in a broader context.

The European Union was essentially a political project - one that would bind the countries of Europe together so that the events of the first and second World Wars would never be repeated.  In that the EU has been phenomenally successful as we have had no or little tension between the members of the European Union, countries that at one time were mortal enemies, since the founding of the Union in 1958.  But the EU has always had economic aspirations, aspirations that any entity its size are likely to have to be a major actor on the world stage.  The single market was the first real sign of those aspirations, and with the visionary Jacques Delors at the helm, the single market became a reality in 1992.  This is basically establishing the EU as a step beyond a free trade area - it is a customs union - a free trade area with common external tariffs.  A free trade area for Europe was a way of stimulating all the economies in Europe after a sclerotic period in the 1980s and the economic theory was completely behind it, as any student of economics will tell you.

All well and good - but Jacques Delors was not content to sit on his hands and let the momentum he had got behind the single market go to waste.  So the single currency was born on the shoulders of the single market, and justified by a now famous document called "One Market, One Money" which was published by the Commission as a justification for moving to a single money as a way to capture all the benefits from the single market plus some additional external benefits as well.  The only problem with a single money is that the economic theory behind adopting a common currency didn't back this further level of integration.

The theory behind adopting a common currency had been done in the 1950s and 1960s by the Canadian nobel-prizewinning economist, Robert Mundell, and is called "optimal currency area theory".  The theory essentially says that countries that have similar macroeconomic variable trajectories over time are likely to be good candidates to join a single currency.  And if there are some countries that don't quite fit the norm, as long as you have a single market for all factors of production and the equivalent of a federal government standing ready to do some redistribution of income, everything should work out alright.  In terms of the application of this theory, only a few decades later when a couple of seminal studies by a UK economist by the name of Michael Artis (University of Manchester) came out using cluster analysis in the late 1990s was it shown how problematic this was in the case of the EU.  If you looked at the pattern of movements in macroeconomic variables for all the candidates eligible and wanting to join the euro, there were clearly at least 3 distinct groups when compared with Germany - the most powerful country in Europe.  One was the so-called "hard core" of countries (all in Northern Europe) that tended to follow the German economy in almost lock step, one was the so-called "soft core" of countries that tended to be in Southern Europe and the third group was a rag-tag group of countries with different circumstances (Finland, Ireland, the UK, to name a few).  Clearly the UK was not what one would refer to as an "optimum currency area".  I even did my own update to the work of Michael Artis and others and it is available in working paper format from the Bank of Finland here.

Now as a side note, some economists (Jeffrey Frankel and Andrew Rose initiated this train of thinking)  made the point that even though the EU has nothing like a federal government to do some transfers of resources between countries that get into trouble, there is likely to be a harmonizing effect as all the member states adopting the euro will have the same monetary policy, which was not the case before they adopted the euro.  This so-called "endogeneity of optimal currency areas" (article available here) was a comfort, and led many to believe that the EU did not need to have the apparatus at a federal or (what the Europeans call a) supranational level in order for the euro to work.

So let's now fast forward to the current problems.  If we look at the groupings of euro area member states (and I am just about to finish a paper which does exactly this) based on how their growth rates are moving together (or otherwise), it is clear that there are basically 3 groups of euro area member states - those that are still in the "hard core", those that have transitioned or are transitioning towards the "hard core", and those that are still far from being in the "hard core" and if anything are moving in the opposite direction (read Greece).  It is therefore clear that unless something is done to give support to Greece's membership at the supranational level (which is unlikely given German opposition to such a development), it should leave.  The big question though is what would happen if Greece left, and how serious the "contagion" would be (some commentators have already claimed that these effects have started see Gavyn Davies's article in the FT here).  I would suggest that economic policymakers should look very carefully at what the economic studies are saying about the other member states that are likely to seek assistance if contagion occurs following a Greek exit (or Grexit as it is now called), before they go down the same path that they have with Greece.  Not all paths are paved with gold, and some might be paved with an awful lot of wasted euros!

The main point here is that if push comes to shove politics will once again trump economics.  The EU leadership can do only a certain amount to help Greece stay in the euro, and because there is little consensus on further help, a point will likely come when Greece either defaults or exits or both.

The Greek Solution

This is the flag that has been carried at demonstrations lately in Athens ( - see this link if you don't believe me). It is easy to see what it represents - the EU flag with a Nazi swastika inserted inside the 12 stars representing the 12 member states that originally formed the European Community. The worrying thing about the demonstrations in Athens is that they clearly represent a large portion of the Greek electorate that do not see the solutions to Greece's problems as more austerity with further bailouts coming from the European Union (through the European Financial Stability Fund of EFSF) or the IMF.  And in my opinion they have a point - we have already been through a series of bailouts and things just don't seem to be getting any better for Greece - each round of austerity measures will just make things worse for the people and the macroeconomy in general.

Today an excellent article appeared in the FT by Gideon Rachman, arguing that further European economic integration in the form of a fiscal union with a European Treasury would not solve the Greek problem, and although I am in favor of moving towards fiscal union, I buy Rachman's argument that Greece is not a compelling reason to do so. Politically speaking though, anti-EU sentiment will continue to rise though unless a "Greek  solution" is found - and this must be a lasting solution, not a patchwork solution as has been done so far. Patchwork solutions risk escalating the crisis into a full blown disaster, with the potential for a breakup of the euro, which would be in none of the participants' interest.  

Would any student of economics be surprised that we've reached this impasse regarding Greece's situation in the euro? No, as the optimal currency area theory suggests that countries whose economies move together are better suited to a single currency, and any academic paper that I've seen since the mid-1990s which tries to operationalize this shows that Greece and several other periphery countries don't have economies that move with the core member states of the euro area.

So according to the academic research, Greece should not be in the euro, but we also know that as the Greek public finances were not complete when they were assessed for membership of the euro back in the early 2000s, they really shouldn't have been allowed to join the euro in the first place. And that is the conundrum here - it is clear to me that the Greek problem is not one that should lead to contagion - it just needs to be solved once and for all - but on the other hand in a monetary union it is not possible to treat Greece as an exception as what you do for one member state you have to do for them all - hence the EFSF.

To end this continuing crisis, I think Greece should be given a choice before it shakes political confidence  in the EU and starts to destabilize the entire euro area as an entity ( - and here I'm not talking about contagion but rather that of credibility). So I would propose that Greece be given a choice - one of their choices should be to leave the euro and return to the Greek drachma so that they can effectively devalue their currency to stabilize their economy (after obviously having to default first), and all those Northern Europeans can then plan their (cheap) vacation in Greece for next summer!  The other choice would be to insist that the Greek parliament change their Constitution so that a 2% of GDP primary budget surplus becomes enshrined into law - thus leaving the decision about how the fiscal policy restraint is going to be implemented up to the Greek parliament. In return for doing this the Greeks would have to submit to scrutiny of their public finances by the European Commission but all negotiations regarding debt issuance and rollovers would be taken from the Greek finance ministry and given to the EFSF to negotiate.  In this way no new debt could be issued (by law) and all the markets would be concerned about would be the rollover of the existing debt and whether payments would be made on the debt.  The EFSF would then also be in charge of making interest payments on the debt, with a maximum of 5% of GDP allowed under normal circumstances ( - which would imply a budget deficit of 3% of GDP, just inside the Stability and Growth pact limits). The interest payments would be billed to Greece.

What are the advantages of the first "Greek solution"?  For Greece, obviously getting out of this mess - but that might be the best option if their politicians do not want to tie their hands. The real losers will undoubtedly be the bond holders, as they will have to take a big haircut given that many of the bonds that have been issued or rolled over are denominated in euros, or face almost certain default. The other big downside would be for the euro area which would have been seen to fail in its attempt to keep a wayward member in the fold.  It's credibility would be mud for a few years, but the financial markets are myopic and that would soon pass.

What are the advantages of the second "Greek solution" I propose above?  In my view it clearly leaves the decision about what to do up to the Greeks, but it also makes very clear that Greece has to pass some "retroactive" tests in order to stay in the euro area, tests that are not being imposed on other member states as they did not misrepresent their public accounts in the first place.  Secondly, the financial role of the EFSF is enhanced, and presumably rolling over/issuing the debt will be easier as it is a European institution with much better credit than the Greek finance ministry that is doing the rolling over.  Third, it also starts us on the road to further economic integration, in the sense of tying the hands of politicians at the member state level, and then allowing the EFSF to manage debt issuance.  It is not fiscal sovereignty at the EU level, but it is a move towards financing public spending at a supranational level.