Yves here. Readers will notice that the author assumes that Greece, even if it goes to the drachma, must maintain balanced budgets because it will need to borrow. In fact, one of the big point of voluntarily going to drachma would be to be able to run fiscal deficits to stimulate the economy.
The New York Times this morning also has an informative op ed on Argentina’s default in the early 2000s. Key section:
By 2001, the nation was caught in a painful crucible of recession and inflation. To Mr. Rodríguez Saá, reneging on a seemingly insurmountable foreign debt seemed a much better idea than cutting workers’ wages and benefits. It also appealed to Argentines as a rebellious cry of independence from the conditions imposed by foreign lenders.
The sense of triumph was short-lived. A week after announcing the default, Mr. Rodríguez Saá resigned. Soon, Argentina lurched into nightmarish chaos.
Economic activity was paralyzed, supermarket prices soared and pharmaceutical companies withdrew their products as the peso lost three-quarters of its value against the dollar. With private medical insurance firms virtually bankrupt and the public health system on the brink of collapse, badly needed drugs for cancer, H.I.V. and heart conditions soon became scarce. Insulin for the country’s estimated 300,000 diabetics disappeared from drugstore shelves.
With the economy in free fall, about half the country’s population was below the poverty line. The country’s middle class took to the streets by the tens of thousands with pots and pans held high, clanging them in what became the echoing beat to Argentina’s 2002 social collapse. “From now on, I sleep with my casserole beneath my bed,” said one woman, proudly proclaiming her commitment to the protest movement.
A run on the banks had already forced the resource-starved government to enact the most draconian economic measures in Argentina’s history. Savings accounts totaling $66 billion were frozen across the country.
Depositors started protesting inside banks. One man went into a bank with a stick of dynamite, demanding his savings to pay for a medical operation for his seriously ill wife. Soon, most of Argentina’s banks were boarded up with thick wooden panels, on which depositors angrily banged their pots and pans.
Well-off Argentines could get around the restrictions. In back rooms, large account holders were able to unofficially withdraw thousands of dollars at a time, or even wire their savings abroad through a growing black market.
For the rest, hundreds of barter clubs popped up around the country. Some were the size of shopping malls, set up in the abandoned hulks of closed factories. Thousands of cashless and hopeless Argentines flocked to them. One opened across the road from Alto Palermo, one of the showiest shopping malls built during the free-market ’90s.
At makeshift stalls, haircuts were traded for psychoanalysis sessions, apple cakes for clothes. By early 2002, the network of clubs was enrolling tens of thousands of glum-faced members every week. When the supply of pesos dried up because of the bank freeze, some of the biggest of the barter clubs began printing their own currency, the crédito.
Charles Wyplosz, Professor of International Economics, Graduate Institute, Geneva; Director, International Centre for Money and Banking Studies; CEPR Research Fellow. Originally published at VoxEU.
When thinking about Greece’s dilemma, two facts from Reinhart and Rogoff (2009) research are highly relevant:
- Defaults on public debts are pretty mundane events; and
- Greece is historically the world’s leading serious defaulter.
What makes the coming event interesting is that it will be the first time that a default occurs within a monetary union.
The crucial observation is that there is no automatic link between a default and monetary-union membership. As we know from previous experiments of government default within the dollar monetary union – the defaults of Orange County in California and Detroit in Michigan – a sub-central government can default and keep the currency. The unique characteristics of such events are that: 1) an exchange-rate depreciation cannot help shift expenditure to the defaulting region’s production; and 2) there is no local central bank to provide liquidity to both the government and commercial banks during the hard phase of the default.
The Greek government might be tempted to recover its own currency but the short-run costs are likely to far exceed the short-run benefits, as explained by Eichengreen (2010). An idea of what would await Greece is provided by Levy Yeyati (2011) in his description of how Argentina gave up its currency board link to the US dollar, an easier case given that the national currency was already in place. The Argentinian example should warn the Greek authorities of the political turmoil that could follow a default.
In the longer run, however, a much-depreciated drachma could lift the Greek economy and, of course, the country might appreciate monetary independence following its wrenching experience inside the Eurozone.
Basically, the trade-off is a major shock and one more year of misery versus the removal of Eurozone membership shackles forever. The balance of benefits is difficult to evaluate since it depends very much on institutional issues that are not clear now. The key questions are:
- Will Greece be able to finally establish on its own fiscal discipline and will its central bank deliver high-quality monetary policy?
- Will the Eurozone draw all the lessons from a Grexit and amend its policies and governance?
In the short run, after a first default, even a partial one, the Greek government will have to balance its books because no one will lend anything any more. ‘Balancing the books’ can mean different things, however.
- One option is to run an overall balanced budget, thus continuing to service the debt after the initial wave of defaults.
The latest European Commission forecasts for 2015 are for a surplus of 1.1% of GDP, after a deficit of 2.5% last year. This might be optimistic as tax receipts seem to have slowed down.
- Another option is to balance the primary budget, which means no servicing of the debt.
The primary budget was just about balanced in 2014. With growth returning to the Eurozone in 2015 and with the end of the fiscal contraction of recent years, this is within reach if the government refrains from many of its electoral promises.
A balanced primary budget would shield the government from external pressure but the size of defaults will grow. It is argued that various debt restructurings have lengthened the average maturity to more than 15 years and provide a ten-year grace period on capital repayment, and even interest service to the European Financial Stability Facility (Darvas 2015). Yet, debt service remains non-negligible, especially for the rest of the year, with a debt service estimated at some $20 billion (8.5% of GDP). It will decline somewhat over the next few years, but not significantly.
Somehow, a debt restructuring, long overdue, will have to follow. There is nothing new here.1 More novel is how a sovereign default can be handled within the Eurozone.
Sovereign Default Within the Eurozone?
Under normal conditions, a country whose government is in default but needs no financing, can remain within the monetary union. Current account deficits, if they exist, represent private borrowing. They are entirely financed, otherwise they would not occur. In the case of Greece, a number of things must happen for it to prosper in the longer run, but there is no immediate macroeconomic pressure that would jeopardise Eurozone membership.
Conditions are not normal, however, and a default would aggravate an already dicey situation.
Many people seem to equate default and Grexit. This is an instance of a self-fulfilling prophecy. If the Greek citizens believe that this is indeed the case, they will not want to keep their savings in Greek financial institutions. In fact, they are already moving them. Since December 2014, when the coming election outcome became obvious, according to various estimates, they have withdrawn about a fifth of their bank account balances. A default would likely trigger a full-blown run on already enfeebled Greek banks.
There is not much debate on how to deal with a bank run.
- First, short of declaring a crippling long-lasting bank holiday, bank withdrawals must be limited, which may, or may not, require controls on capital outflows.
- Second, the authorities must move to urgently stabilise the banking system.
This may involve urgent large-scale lending to solvent banks, and the takeover of insolvent banks.
In such a situation, determining bank solvency is more art than science, so value judgement is unavoidable. But who are the authorities? The defaulting government and the central bank. Either the government receives emergency funding, which is likely to be ruled out, or the central bank must foot the bill entirely on its own. That effectively means the ECB. As De Grauwe (2011) convincingly argued, the sovereign debt crisis only occurred because the euro was a foreign currency to Eurozone member countries.
- If, in the face of a bank run, the ECB does not act as lender of last resort, the Greek government will have no choice but to leave the euro under the most unfavourable of all circumstances.
Since the onset of the slow-motion bank run, the ECB has dithered. Its instrument, the Emergency Liquidity Assistance facility, leaves quite some discretion in the hands of the central bank. It has a ceiling, which it has raised repeatedly. It must list what is acceptable collateral, and the list has been repeatedly expanded. Since much of the collateral of Greek banks is soon-to-be-defaulted-upon Greek government debt, it is understandable that the ECB proceeds with caution.
- Once, following a default, a bank run is under way, in principle Greek bonds will not be acceptable to ECB; with no central bank able to act as lender of last resort, the Grexit prophecy will have become reality.
What this all means is that, if the aim is to avoid a Grexit, it is not possible to wait for a default to happen.
Avoiding Grexit Means Avoiding Default or Lining Up a Lender-Of-Last-Resort
The vicious cycle that underpins the self-fulfilling prophecy must be broken now. That means ruling out either the first or the last step of the cycle.
- The way to avoid the first step, default, is to announce an agreement in principle to reduce the public debt of the Greek government.
- The way to avoid the last step, Grexit, is to announce that resources to thwart a bank run are available.
These announcements must be unconditional – independent of an agreement on the assistance programme – because it seems that such an agreement is beyond reach.
The problem is that European authorities are bound to find it politically impossible to give in, ditch the pre-existing agreement and abandon conditionality. Economically, they also face a conflict of interest. About 80% of the Greek debt is now owed to officials, the European authorities and the IMF. The official rhetoric is that “we have done enough for Greece”.
So far, however, the Europeans have not made any present to Greece,2 only loans, initially on harsh financial conditions, then sweetened. A default would turn the loans into presents. Making it possible for Greece to comfortably default does not seem appealing at all.
National governments are elected by their citizens so they are most unlikely to act to prevent a Grexit. One more time, we have to turn to the ECB, whose essential mandate is to uphold the Eurozone.
It may be unfair, but the ECB’s duty is to announce very soon that it will do whatever it takes to keep the Eurozone whole.