GREXIT

Si vis pacem, para bellum – If you want peace, prepare for war, said Vegetius in the 5^th-6^th century b.C.  Just as then, and by the same token, Si vis euro, para exitum: if you want to keep the euro, prepare for exit.

In 2012 Willem H. Buiter and Ebrahim Rahban, respectively chief economist and global economist of Citygroup, writing in the Market Insight section of the Financial Times (Greece far from safe even after debt swap, 13 February), coined the word Grexit – a euphonic synthetic neo-logism for Greek exit from the Eurozone.  They wrote then:

“There is some good news. Plentiful ECB liquidity has pushed back the risk of disorderly default of systemically important euro area banks and, combined with financial repression in euro periphery nations, has eliminated the near-term risk of a disorderly default by a systemically important sovereign. The external damage caused by a Greek euro area exit (or ‘Grexit’, as we call it) could, given appropriate policy response from the ECB and euro area creditor countries, be limited and need not trigger waves of “exit fear contagion” to other fiscally weak peripheral countries. The second LTRO on February 29 may buy more time but until the fundamental drivers of the euro area sovereign debt and banking crises are addressed, volatility will remain a constant companion and recovery and growth absent friends”

Since the unexpected victory of Alexis Tsipras and his Syriza Party, elected on 25 January 2015 on a programme rejecting European austerity and its embodiment the Memorandum imposed by the Troika (EC, ECB and IMF) on the Samaras government, references to Grexit have become increasingly frequent, including its variation Grexident (Wolfgang Schauble) to indicate the possibility of Greek “accidental” exit, in spite of neither the Greek government nor European authorities (perhaps not including Schauble) actually wanting to provoke that event.

Three observations are in order.

1) There are serious legal problems involved in Grexit. 

For a start, there is no legal provision in the Treaties for an EMU member state to withdraw from or be compelled to leave the Eurozone. The decision to introduce the euro is “irrevocable” (Art. 140 TFEU).  The same was true for the EU as well. Article 50 TEU, however, grants EU member states the right to withdraw from the European Union. It is inconceivable, though it has not been explitly stated, that a country could leave the EU and still maintain all the rights reserved to EMU members. Conversely, membership of the EMU is part of the obligations of membership, the so-called acquis communautaire, unless a derogation had been successfully negotiated in 1992 at the time of signing the Maastricht Treaty.  Therefore a State that left EMU or, by some unspecified measure, was no longer a member of EMU would have to leave the EU as unable to fulfil its membership requirements.  And even if a country was allowed such a derogation ex-post, thus maintaining EU membership, it would still be subject to the fiscal straightjacket of the so-called Growth and Stability Pact and the Fiscal Compact, i.e. the exit from EMU would not restore a country’s fiscal sovereignty.  Unilateral exit from the EU would take effect only two years after its declaration, but we must presume that exit from the EU of an EMU member would involve its immediate exit from the Monetary Union.  The immediate implementation of capital controls and ceilings on cash withdrawals from banks, in order to avoid capital flight and bank runs, would certainly follow. That the Council, the European Parliament and the relevant Greek institutions would have to be consulted beforehand would also and detrimentally make secrecy impossible.

2) Grexit would involve the problems of managing the new currency. 

The rate of conversion of the old into the new currency would have to be identical, at least to start with, with the rate of conversion of euro prices and wages into the new currency. Without loss of generality therefore at time 0 the new currency could be initially issued at par with the euro.  Immediately afterwards, however, the exchange rate between the old euro and the new currency, let us call it the drachma, would necessarily have to be floating, fully determined by the market. At any managed exchange rate different from the market rate Gresham's Law would operate: “Bad money [i.e. the currency overvalued with respect to the market rate] drives out good [the undervalued currency]”. One of the oldest economic discoveries, anticipated in 1519 by Copernicus, even earlier by Nicole Oresme in the fourteenth century, the law was first stated clearly by Aristophanes in his play The Frogs, around the end of the fifth century b.C.

The new currency would have to be devalued, very soon after issue, for the exiting country to obtain the benefits of greater international competitiveness and devaluation of debt payable in that currency.  (Wolfgang Munchau expects the new currency to continue to circulate at par with the euro voluntarily on a significant scale, but this is unrealistic). However the currency to be used for discharging earlier obligations cannot be chosen at will; it is determined by the law of the country where the transaction has taken place.  Thus, for instance, much and probably most of the outstanding import and export orders, as well as past unpaid tax, and the servicing of already existing debt will have to continue to take place in euro, under penalty of default; overall, something like 30% of debt and almost all of derivatives trade. Target 2 large balances – a purely technical construct while the euro lasts – would become real and would have to be settled or canceled, coming to a head.  And furthermore “Dual currencies are always a bad idea” (this Blog, 10 February 2010).  

Euro denominated obligations contracted under the law of a non-Eurozone country like Britain will have to be discharged by converting the new currency into euros at the market exchange rate.  Thus the introduction of the new currency would not avoid default, it would simply be the form that a default would take.  As well, a default would involve the inability to access international financial markets for the next 10 or 15 years and/or a much higher cost of finance.

The devaluation of the new currency would necessarily involve an acceleration in inflation with respect to euro inflation, and therefore an increase in the interest rate with respect to euro rates, and especially a higher spread with respect to German Bunds. The impact of the new currency on external accounts, income and employment, will depend both on its subsequent impact (“pass-through”) on the path of wages and prices inflation, and on trade elasticities of both demand and supply; in principle perverse effects cannot be ruled out.  In the end the success of a euro exit would depend on the flexibility of real wages and prices, as well as on the country’s ability to implement productivity-enhancing policies, which are the same conditions under which the maintenance of a common currency would work.

3) Grexit would never be accidental.

Grexit would be the result of a deliberately destructive strategy adopted by Germany and the Nordic countries (Finland, the Netherlands, France, the Baltics) aided and abetted by Spain and Portugal for fear of opposition parties ousting their governments should Syriza’s example succeed, and by Italy out of perceived self-interest.  The Greek refusal, backed by the new elected government and today reportedly supported by 80% of the Greek population, to continue with the self-defeating, ruinous austerity policies imposed from Brussels, Frankfurt, Berlin and Washington, is a completely rational and democratic choice rather than the reckless strategy in an irresponsiblee game of “chicken” of which Greece has been accused. 

The most likely course of events leading to Grexit would be: the continued denial of Greek access to any of the €7.2bn residual funds provided by the Troika’s earlier rescue package, while Troika officials slowly verify compliance with outdated conditions, impossible for a poor country to satisfy; the continued prohibition by the ECB of the Greek government raising finance through the issue of short term Treasury bills, indeed the imposition of ceilings on banks’ holdings of such bills, under the pretext that in Greek circumstances this would amount to funding the government deficit directly (a peculiar dysfunction of the ECB, seeing that the independent Bank of England and the independent Central Bank of Japan are allowed to fund government deficits all the time). 

At the end of March the Greek government is facing a bill of €1.7bn for wages and pensions; on 9 April the IMF is owed a loan repayment of €450mn, and in mid-April two Treasury bills for a total of €2.4bn also are due for repayment.  

Since the elections of 25 January Greek corporations and households have cut their tax payments drastically; a government running a primary surplus, even at the reduced rate of 1.5% of GDP, should always be able to finance current public expenditure but now the position is unclear.  The Greek government has been particularly skilled at mobilizing cash belonging to the National Health Service and state-owned corporations to  keep the government afloat. But cash withdrawals from the banks have been accelerating since the new year, both before and after the elections.  According to Barclays on Wednesday 18 March withdrawals reached a record €300mn per day, at which rate they regarded a block on deposits as unavoidable (not least because of this kind of malicious rumour).  The Greek government has admitted that without fresh funds they will not be able to meet all payments due in April: we should believe them.  Failure to repay the IMF loan instalment would not have immediate adverse implications, but would involve the loss of all IMF credits.  Failure to repay the €2.4bn Treasury bills would trigger-off cross-default clauses in other loans and precipitate a deeper crisis, including the likely loss of ECB Emergency Liquidity Assistance.  At that point a run on the banks, stricter limits on bank withdrawals, capital controls and actual default would become self-fulfilling prophecies.  In order to avoid the de-monetisation of the economy and its vast contractionary implications the government would be forced to issue a euro substitute, i.e. a new currency parallel to the Euro.

The transition to the new currency presumes that the new banknotes and coins can be produced quickly or, better, well in advance in complete secrecy. Normally this would take about six months; it has been suggested that the new currency could be introduced by stamping old euro notes as drachmas, but this would be a silly waste of good money.However a cash shortage could be initially tackled by means of the issue of small denomination Treasury notes, or by the issue of bank cheques like those that were introduced in Italy in the 1980s to deal with a shortage of coinage. At least initially, and indeed for some time, the euro and the new currency would circulate in parallel, but as long as the rate of exchange between the two was market determined this should not create problems other than some confusion and uncertainty.

It might be safest to turn our deposits into bricks and mortar, withdraw as much cash as we can as fast as we can while we still can, and hide it under the mattress to avoid negative interest rates. Actually, si vis pacem para pacem, as Pope Francis might have said, and if you want to keep the Euro get on with completing a banking Union, promote fiscal and political integration; above all Growth and Stability suicide Pact must be imaginatively re-interpreted and accompanied by a serious, large scale, European public investment effort. Together with the felicitous large reduction in oil price, overdue but welcome Quantitative Easing by the ECB and substantial euro de-valuation, this might still do the trick without the drama and trauma of Eurozone and European Union dis-integration.

Cucumber season

The Silly Season, or Cucumber Season as it is called in several European languages – the diffusion of frivolous news to compensate for the mid-summer rarefaction of real events – has begun early this year. On 6 May Der Spiegel reported that “Greece Considers Exit from Euro Zone” with a view to re-introduce the Drachma, negotiating to that effect with EC and Eurozone authorities at “a secret crisis meeting in Luxembourg” that evening. The fact that the meeting was at first officially denied by Luxembourg Premier Jean-Claude Juncker, then admitted ("When it becomes serious, you have to lie"), lent credibility to the story. The euro lost 2 cents overnight with respect to the dollar.

No Exit

This non-scoop is utter nonsense, and not just because there is no provision for exiting the Eurozone other than by leaving the European Union – a drastic and traumatic step in nobody’s interest. Nor just because this would annihilate the Greek banking system (and heavily damage German and other European banks, including the ECB), or because Euros in the hands of the Greek public would continue to circulate – possibly curtailed by the amounts that the Greek public might be unable to recover from their banks (though they have already salted away €30bn abroad as a result of the crisis). Nor just because Greece would lose the financial support already committed by European institutions (half of €110bn, which have not yet been disbursed), and support lined up in the near future (there is current talk of another €60bn).

Greek exit from the euro is nonsense primarily because the re-introduction of the drachma would not allow Greece to reduce its debt denominated in euro through drachma inflation. The euro debt would rise in terms of drachma through drachma devaluation to compensate for drachma differential inflation with respect to the euro, and remain exactly the same as before the exit.

True, the possibility of drachma devaluation – beginning with the re-introduction of the national currency – might make Greece more competitive and make it prosper to the point of re-gaining solvency. But if a devaluation was 1) politically acceptable (unlikely, after 10 general strikes since the first austerity measures were introduced by the Socialist government) and 2) economically effective (in terms of import and export elasticities with respect to devaluation), the Greek government could replicate its effects via a Latvian-style domestic deflation without the additional costs and turmoil of leaving the Euro.

Which is why Greek exit from the euro is a non-starter, pace Der Spiegel’s news and Hans Werner-Sinn’s advocacy. The only other two possibilities are: a bail-out, or a default: Quartum non datur, to coin an expression.

No Bail-Out

When a debtor is solvent but illiquid, a bail-out involves temporary assistance, perhaps by European institutions on terms friendlier than those that might be offered otherwise by financial markets, with full later re-payment. But there is an increasing consensus that certainly Greece – at any rate, leaving aside the similar cases of Ireland and Portugal – is not illiquid but insolvent. The provision of additional loans to allow Greece to repay outstanding loans as they mature, at an interest rate higher than the likely growth rate of the country's GDP (taking both either in nominal or real terms) is a recipe for bankruptcy – unless there is a commitment, on the part of European institutions, to continue to provide non-repayable loans until Kingdom Come.

Paradoxically, this kind of approach appears to have a Keynesian connotation. In “Economic Possibilities for our Grandchildren” (1930) Maynard Keynes quotes approvingly a passage from a book by Lewis Carroll, 1889, [Ch. 10, The other Professor]:

“Let me remind you of the Professor in Sylvie and Bruno:”
[“Come in!”]
“Only the tailor, sir, with your little bill,” said a meek voce outside the door.
“Ah, well, I can soon settle his business,” the Professor said to the children, “if you’ll just wait a minute. How much is it, this year, my man?”
The tailor had come in while he was speaking.
“Well, it’s been a-doubling so many years, you see,” the tailor replied, a little grufy, “and I think I’d like the money now. It’s two thousand pound, it is!”
“Oh, that’s nothing!” the Professor carelessly remarked, feeling in his pocket, as if he always carried at least that amount about with him.
“But wouldn’t you like to wait just another year and make it four thousand? Just think how rich you’d be! Why, you might be a king, if you liked!”
“I don’t know as I’d care about being a king,” the man said thoughtfully. “But it dew sound a powerful sight o’ money! Well, I think I’ll wait-“
“Of course you will!” said the Professor. “There’s good sense in you, I see. Good-day to you, my man!”
“Will you ever have to pay him that four thousand pounds?” Sylvie asked as the door closed on the departing creditor.
“Never, my child!” the Professor replied emphatically. “He’ll go on doubling it till he dies. You see, it’s always worth while waiting another year to get twice as much money!”

The trouble is that this approach can hold only in Lewis Carroll’s Wonderlands, for in the real economy there simply may not exist an interest rate such as to make a creditor, or the financial market as a whole, willing to renew a mature loan in its entirety for another period – let alone another and another. The creditor is more likely to want to cash in at least some of his credit and of the accrued interest, and re-lend only the rest. Clearly Maynard Keynes was not being serious, he was only amusing himself with literary references, as he might have done in conversation with fellows and guests at High Table dinner or over Wine Room drinks.

Bail-outs as Ponzi Schemes

The nature of European bail-outs has been well understood and demonstrated in an article in the Financial Times of 5 May by Mario Blejer – former Governor of Argentina’s Central Bank and director of the Centre for Central Banking Studies at the Bank of England. Blejer likens financial support for Greece, Ireland and Portugal to a giant “pyramid or a Ponzi Scheme”. Ponzi paid insustainably high interest rates out of new deposits, before running away with the residual loot. European bail-outs involve the accumulation of non-sustainable interest rates without the possibility of their ever being paid together with the original loans. The principle is the same.

The bail-outs raise total debt and its share of GDP. “A case in point is the €78bn ($116bn) loan to Portugal. It is equivalent to more than 47 per cent of its gross domestic product in 2010, possibly increasing Portugal’s public debt to about 120 per cent of GDP.”

“It could be claimed that this mechanism is helping the countries involved since the official loans, although onerous, carry better conditions than the ones that need to be serviced. But the countries’ debts will increase (as a percentage of GDP the debts of Greece, Ireland, Portugal and Spain are expected to be higher by the end of 2012 than at the start of the crisis). The share of debt owed to the official sector will also increase (in addition to the bond purchases by the European Central Bank, which reportedly owns 17 per cent of these countries’ bonds with a much higher percentage held as collateral).”

“Some of the original bondholders are being paid with the official loans that also finance the remaining primary deficits. When it turns out that countries cannot meet the austerity and structural conditions imposed on them, and therefore cannot return to the voluntary market, these loans will eventually be rolled over and enhanced by eurozone members and international organisations. … “… this “public sector Ponzi scheme” is more flexible than a private one. In a private scheme, the pyramid collapses when you cannot find enough new investors willing to hand over their money so old investors can be paid. But in a public scheme such as this, the Ponzi scheme could, in theory, go on for ever. As long as it is financed with public money, the peripheral countries’ debt could continue to grow without a hypothetical limit.”

Except that there is a political limit to solvent countries’ willingness to take on the debt of those insolvent: “We are starting to observe public opposition to financing this Ponzi scheme in its current form, but it could still have quite a way to go. It is apparent that, if not forced sooner by politics, the inevitable default will only be allowed to take place when the vast part of the European distressed debt is transferred from the private to the official sector. As in a pyramid scheme, it will be the last holder of the “asset” that takes the full loss. In this case, it will be the taxpayer that foots the bill, rather than the original bondholders that made the wrong investment decisions.”

Blejer points out that the desirability of this approach depends entirely “on how one assesses the value of the time gained. Would a bank crisis now be more damaging to the European economy than a future debt write-off? Or, alternatively, is recognising reality and accepting a debt restructuring now preferable to increasing the burden on future taxpayers? At the end, it is a political decision, but it would be refreshing if things are called by their name. Euphemisms may be useful in the short run, but one finally recognises a Ponzi scheme when it persists.”

No Default?

The undesirability and ineffectiveness of exit from the Eurozone, and the Ponzi-like nature of continued assistance to insolvent sovereign debtors, leaves only one option: default – preferably consensual, negotiated with creditors rather than unilaterally declared and abrupt; in the form of lengthening debt maturity, interest rate haircuts, as well as debt reduction, but default nevertheless. There is no way “No Exit, no Bail-Outs, no Default”, or immovable objects and irresistible forces, can co-exist other than in a Wonderland.

Richard Portes (who was involved in Poland’s 1981 default) makes a powerful case for the restructuring of Ireland’s debt: “A reasonable target would be a debt reduction of €40-50 billion, in present value. That is on the order of 30% of GDP and would bring the debt ratio down to a sustainable 80% or so. The required haircuts would be in line with current market valuations of Irish sovereign debt.”… “Of course, there is a way for Ireland to escape responsibility. Just wait for Greece to restructure its debt, at which point there will be general confusion and the markets will shun Ireland anyway. Then restructure, when it will be widely accepted as unavoidable. Maybe that is the unspoken strategy. If so, there may not be long to wait.”

Martin Wolf (in his FT Column of 11 May) works out that with a debt/GDP ratio of 160%, and with very optimistic assumptions of a 6% interest rate (less than half of the current 15%, or the 25% on two-year bonds), and a 4% nominal growth rate, even to stabilize debt Greece would need to run a primary surplus (before interest payments) of 3.2%; and a 6% primary surplus would be necessary to reduce the debt/GDP ratio down to the Maastricht Treaty ceiling of 60% by 2040. “Every year, then, the Greek people would need to be cajoled and coerced into paying far more in taxes than they receive in government spending.” “What might persuade investors that this is sufficiently likely to justify funding Greece? Nothing I can imagine. But remember that 6 per cent would be a spread of less than 3 percentage points over German bunds. The default risk does not need to be very high to make this extremely unappealing.”

Wolf recommends “a pre-emptive restructuring of the debt, perhaps next year. Since market prices tell us that this is what investors expect, it should not come as a shock to them. A restructuring ought to raise the country’s creditworthiness and increase the incentives to sustain a programme of stabilisation and reform. Moreover, with a planned, pre-emptive restructuring the authorities could also prepare the needed support for banks, both inside Greece and outside it.” “Overindebted countries with their own currencies inflate. But countries that borrow in foreign currencies default. By joining the eurozone, members have moved from the former state to the latter. If restructuring is ruled out, members must both finance and police one another. More precisely, the bigger and the stronger will finance and police the smaller and the weaker.”

What used to be isolated voices contemplating default are turning into an increasing chorus. “A Reuters poll finds that investors and economists believe Greece will have to restructure its sovereign debt, with 14 out of 15 fund managers and 26 out of 28 economists polled. Opinions are more divided when it comes to the timing. Half of these economists and a third of the fund managers believe it will happen after April 2012. From those 11 economists and 8 fund managers believe restructuring will happen through haircuts, while a majority believes it will happen through extending maturity and lowering interest rates.” (Eurointelligence.com, 13 May). “FT Alphaville picked up on a paper by Barclays Capital, which looked at the haircut needed by Greece to achieve a primary balance - which is 67% in 2012 – based on a primary balance of minus 2.5% this year. It goes into a great detail about recovery values to conclude that the situation is really messy.” (Ibidem).

The most vocal opposition to any talk of default comes from Lorenzo Bini Smaghi, at present a member of the ECB Executive Board. Bini Smaghi’s solution of the sovereign debt crisis is the issue of European sovereign bonds, that would compete with US Treasury Bonds, lowering interest rates and financing the bail-outs. It is immensely naïve to believe that a EU institution, backed by a tiny budget of just over 1% of EU GDP and a built-in zero primary surplus might successfully compete with the US Treasury, with a tax revenue of over 35% of GDP out of which it is conceivable that a primary surplus sooner or later might be sufficiently high to service its debt.

With Mario Draghi’s coming appointment as ECB President, after Angela Merkel’s endorsement, Bini Smaghi is expected to have to leave his ECB post to make room for a Frenchman, and was considered to be in a strong position for a bid to succeed Draghi as Governor of the Bank of Italy. But other frontrunners for the post, Vittorio Grilli (Director General of the Italian Treasury and the president of the EU’s economic and financial committee), Fabrizio Saccomanni (the Director General of the Bank of Italy) and Ignazio Visco (his deputy), are less committed to Bini Smaghi’s agenda. Certainly Draghi has already stated firmly that there can be no European sovereign bond ahead of Fiscal Union. Maybe he will also be more open to orderly but unmitigated defaults, before the sovereign debt crisis becomes unmanageable.