James Bevan: Greece, default and reminding investors of risk

With the recent 70^th anniversary of VE Day it’s easy to understand the motivation of the proponents and indeed the architects of the Euro, seeking to diminish nationhood in favour of a more collective and cohesive regional whole. But as Keynes points out in his Treatise on Money, the Euro needed to be created after a single Europe had been formed. Absent the real mechanism to address intra-Euroland divergences, the Euro as currently structured has fatal fault lines.

Many trustees ask if Greece can or will remain in the Euro, and our stock answer is that Greece will be in the Euro as long as there is a Euro and that Greece will likely not be the country that wrecks the system. Put simply, Greece doesn’t want to leave.

If Greece were to leave unilaterally, it would cause chaos in the interbank markets and contagion that would result in Euroland interbank rates diverging across countries, with the Euro evolving back in to the ERM; it would increase pressure on TARGET2 (particularly while the ECB is running its QE) and it would challenge the legitimacy of the ECB’s power over its member states. Against this backcloth, the likely costs of ejecting Greece, or allowing it to walk away, far outweigh the costs of keeping Greece within the euro.

The next question is how can this be achieved. Euroland’s first move was to call for austerity to create competitiveness and large current account surpluses to repay the debts that the ECB’s own interest rate policies had encouraged Greece to take on in the late 1990s and 2000s. Yet Greece’s position was perhaps four or five times as bad as that of Thailand in 1997 and Thailand needed not only a decade of adjustment but also a massive devaluation before it was able to emerge from the chaos that had, in part, been caused by its previous adherence to a fixed exchange rate regime.

Today, after some five years of austerity following the onset of its crisis, Greece has made little progress in reducing its debt ratios, with the debt burden higher now than in 2010. Meanwhile, domestic investment has all but collapsed (which is bad news for the longer term), the level of consumer spending has fallen back to levels not seen since the turn of the century and social unrest has remained elevated. What’s more Greece has not been able to generate either the types of large current account surpluses, or the large inflows of direct investment, or even the high levels of inward portfolio investment that would have been necessary to generate the foreign receipts that could be used to actually reduce its debt burden. Greece did succeed in producing a few brief months of current account surpluses at a time in which domestic economic activity was collapsing –  but as soon as the economy exhibited any signs of even tentative stability, these surpluses disappeared, leaving the country unable to repay its debts.

It’s clear, as Professor Michael Pettis has pointed out, that at least some of the Euro Crisis can be described within the context of the tension that exists between protecting the rights of creditors and much of the commentary provided by entities which serve creditors. And there’s the ugly reality that Greece’s failure to produce external current account and investment flow surpluses to successfully service its debts has occurred despite a reduction in labour costs and the accompanying social costs. Even more austerity really doesn’t look useful or wise. Instead, we can argue that it’s time to recognize that not only did Greece borrow too much money, but the world also lent Greece too much money – with the implication that there should therefore be an equitable sharing of the pain.

In practical terms, Greece would probably need to run current account surpluses of over 10% of its GDP for much of the next decade simply to repay half of its existing debt burden and to achieve that would probably require another 20–30% decline in domestic demand (assuming that world trade at least revived to some extent). Frankly, we can see no practical or morally acceptable way in which that could be achieved.

Greece needs to default and reasonably should be allowed to default – both for Greece’s sake and also to remind international investors that default risk does indeed exist even in a QE world.

If enough of Greece’s debts were to be cancelled and the banking system refinanced where necessary, it is likely that the economy might well recover under its own steam even within the confines of the Euro System. If there was messier case-by-case default, taking time to occur if only to prevent systemic failures amongst the creditors, Greece may need its own recovery plan – which could sensibly involve monetized fiscal expansion, providing a direct boost to aggregate demand via an increase in government investment expenditure on infrastructure, education and small company financing. As for magnitude, the first year stimulus would likely need to be €10-20bn, taking the Greek budget deficit to around €23b, very roughly the same as in 2012.

A key issue would be how to fund such a deficit given prevailing conditions within the bond markets. In a perfect world, the ECB/Bank of Greece would allow or simply compel the domestic banking system to fund the deficit entirely in euros, even if this required the ECB to provide further short-term ELA assistance to the banks (and probably quite a lot of automatic TARGET2 assistance as some of the new money that was created attempted to flee Greece).

Whilst massive internal and external debt forgiveness, or failing that a simple monetized expansion of the budget deficit by the Greek banking system with liquidity support from the ECB (notionally very similar to the ECB’s QE) are the obvious answers, Eurolanders may baulk. But austerity has failed and it does not offer a viable or morally justifiable solution to the Greek Crisis, while Grexit would likely prove too costly for Europe to countenance. Europe needs to recognize that widespread cancellation of Greece’s internal and external debt burdens and/or a Euro-monetized expansion of fiscal policy would be relatively easy to engineer if the political will is present.

The only other choice might be a parallel currency, but this would be a dangerous option.

If Greece did create a parallel currency, it would be declared as legal tender by the government and legislated as being an acceptable measuring tool (i.e. prices could and would be denominated in it as well as the Euro). The government would hence forth settle all new debts and domestic contracts in this parallel currency, thereby creating an initial supply of the new currency. Commercial banks would be allowed to offer, subject to their capital adequacy positions, both loans and deposits denominated in the parallel currency as well as in euro. The Bank of Greece would fix the exchange rate relative to the euro and offer to swap at that rate if the parallel currency fell against the euro, and sell the parallel currency if it traded above the rate.

Were the parallel currency to be introduced, it might well fall to an initial discount against the euro and quoted parallel currency prices would likely be higher than euro prices when converted at the official exchange rate. However, were this to happen, it would in theory be possible for people to buy goods in euros, then sell them in the parallel currency and then take that parallel currency to the Bank of Greece and convert back into euros at the official rate, thereby yielding a profit. The same form of arbitrage would also be possible within the loan and deposit markets, and that should ultimately bring the two currencies back into line.

The two key requirements of this internal form of a currency board would be that the exchange rate was perceived as credible and the Bank of Greece had sufficient physical euros in stock to survive the probable initial rush to dump the parallel currency and buy euros. Interestingly, when the HK dollar was introduced in similarly dire domestic circumstances in 1983 (i.e. potential hyper-inflation and even a perceived threat of invasion), the physical demand for US dollars was nowhere near as high as many had expected it to be – the Boeing 747 that was reportedly on stand-by full of US dollar bank notes was never needed. As for making the currency link credible, it would have to be endorsed not just by the Greek government but by the ECB, IMF, OECD, the European Parliament and other bodies.

Let’s hope that sanity prevails – but investors in Greek government bonds need to recognize that their positions are now inherently speculative.