Tuesday, June 30, 2015

The Main Policy Lesson from the Greek Crisis

A main conclusion to be drawn from the Greek crisis is that an external currency regime is no cure for lax budget policies, writes Megan McArdle in a Bloomberg post today. On the contrary, I would add, an external currency can be a main cause of disequilibrium in public finances since a disequilibrium exchange rate stifling growth effect is likely to incite a government to recourse to more public spending and budget deficits in the hope of compensating for the deflationary monetary policy effect.

Here is a quote from her post:

“It's easy to moralize Greece's feckless borrowing, weak tax collection and long history of default, and hey, go ahead; I won't stop you. But whatever the nation's moral failures, what we're witnessing now shows the dangers of trying to cure the problems of weak fiscal discipline with some sort of externally imposed currency regime. Greek creditors and Brussels were not the only people to joyously embrace the belief that the euro would finally force Greece to keep its financial house in order; you hear the same arguments right here at home from American gold bugs. During the ardent height of Ron Paul's popularity, I tried to explain why this doesn't work: "You don't get anything out of a gold standard that you didn't bring with you. If your government is a credible steward of the money supply, you don't need it; and if it isn't, it won't be able to stay on it long anyway."

This goes double for fiscal discipline. Moving to a fixed exchange rate protects bondholders from one specific sort of risk: the possibility that inflation will erode the real value of your bonds. But that doesn't remove the risk. It just transforms it. Now that the government can't inflate away its debt, you instead face the risk that they are going to run out of money to pay their bills and suddenly default. That's exactly what happened to Argentina, and many other nations on various other currency regimes, from the gold standard to a currency peg. The ability to inflate the currency had gone away, but the currency regime didn't fix any of the underlying institutional problems that previous governments had solved with inflation. So bondholders protected themselves from inflation, and instead took a catastrophic haircut.

In financial markets, it is easy to move risk around and change who is bearing it. On the other hand, it's very hard to actually get rid of the risk. The biggest problems come when we think we have -- when we mistake risk transformation for risk avoidance. That's what happened in 2008, and that's what happened with Greece: Creditors acted like the risk that Greece wouldn't be able to pay its bills had somehow been eliminated once it moved to a harder currency. When everyone starts pretending that we've suddenly stumbled onto a sure thing, the safest bet is that we're in for a lot of drama.”

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

Monday, June 29, 2015

A Plan of Hope for Greece

Both Project Syndicate and Le Figaro declined to publish the following proposal. Given the type of analysis that they use to publish I take that rejection as a compliment.

In “A plan of hope for Greece” I argue that the main cause of the present and dramatic difficulties of the Greek economy is the grossly mispriced exchange rate implicitly embedded in the euro and that, as a consequence, the return of the Greek economy to growth requires above all a return to monetary independence and a substantial devaluation of a new Drachma vis-à-vis the euro. Instead of waging a “war of secession” against Greece and try to impose further austerity to a deflationary economy, the other EU and Eurozone nations should recognize that a major debt relief is unavoidable and should be accompanied by a generous “new Marshall Plan” that would guarantee a continuing access of the Greek government to international financing during a transitional, post-Grexit, period. It must be understood as the price to pay in order to avoid a much more costlier permanent “transfer economy” from the North to the South of the EU, and the condition for a stabilization of Europe’s interests in the Balkans and the Middle East powderkeg.

A Plan of Hope for Greece

Jean-Jacques Rosa

June 27, 2015

No solution to the Greek problem is possible as long as the question is framed into a restrictive confrontation between the creditors’ injunction “commit to reform (i.e. spending cuts and tax increases) to get liquidity” and the Greek government’s rebuttal “debt relief first” and “we chose our own cuts and taxes”.

It should be recognized that a Greek recovery is possible but requires, as a sine qua non condition, an exit from the euro, and this in turn can only succeed if conceived in a spirit of European solidarity. It is imperative both to restore hope to the Greek society and to reassure other members of the EU that do not wish to shoulder the burden of a permanent transfer society, but want to preserve the political union of the continent. European leaders should offer Greece a modern Marshall Plan, which ought to be an essential element in a strategy of controlled exit of Greece from the eurozone.

Despite the previous 2012 partial defaults on external debts, the Greek economy is still mired in hopeless depression and continued deflation. While the current debt burden of about 180% of GDP, and growing, is simply not sustainable, additional spending cuts required by the creditors’ cartel will aggravate depression, and additional liquidity, if supplied, will further deteriorate the debt/income ratio, thus intensifying the debt-deflation vicious circle.

The fundamental cause of the problem is that a small, and by necessity very open, economy is easily sunk by an inadequate, mispriced, exchange rate. Since the entry in the Eurozone in 2001, the massive divergence of costs between Greece and its main partners, which are all members of the zone, has resulted in the equivalent of a massive exchange rate revaluation. Greek products (including tourism and shipping) are now priced out of foreign markets while Greek imports became relatively cheaper than local products, depressing local activity. This accumulated chasm should take several more years of deflation, depression, and misery to be breached. This is politically and humanely impossible.

The obvious and quick solution then is to devalue a new Greek currency vis-à-vis its Eurozone partners and complement that by a major debt relief. This is a classical, well known, mainstream economic solution to this type of problem. But that strategy is ruled out by the cartel of creditors and the authorities of “institutional Europe” for fear of the contagion effect that a Grexit would produce on other struggling southern economies, and of a subsequent unraveling of the euro. The Greek government, on the other hand, fears to renege on its electoral promise to stay in the euro, and also to lose access to international financing coming currently mostly from other European governments, so that an exit would mean, in the short run, an aggravated economic slump and more bankruptcies before the economy can benefit from a return to growth. 

Moreover a confrontational exit, a “war of secession”, would weaken the EU itself at a time of major political and strategic uncertainties in the Middle East and Central Europe.

A positive aspect of the problem, however, is that its magnitude is small. Greece’s GDP amounts to only about 2% of EU’s GDP, and thus its overall debt can represent no more that 4% of overall EU’s GDP. Thus, helping the Greek economy to return to growth and hope is a relatively minor task compared, for instance, to what was the European problem at hand in 1945. Currency reform and the Marshall plan aid helped devastated Germany to reconstruct its economy and return to brilliant growth, a policy that Mr. Schäuble and Ms. Merkel should remember and ponder. The reason and generosity that prevailed then should also prevail today.

Accordingly, all parties would benefit from the following strategy: complement a Grexit – a return to the Drachma with a radically lowered parity to the euro -- with a major debt relief (50% or more) and a guarantee by the creditors governments – and the so-called Eurogroup -- of a continued access by Athens to ECB’s very low interest rates borrowing during a transition period, let’s say of five years. It would be during that period that a reform and budget consolidation could take place in step with the return to positive growth rates, and not before.

The European northern creditors would thus trade the necessity of continued transfers to an ailing Greek economy for an indefinite future for a one shot temporary aid that would really restore its capacity to grow, as it clearly existed before the fateful entry into the Eurozone.
Such a strategy would rather strengthen the euro than weaken it, vindicating the commitment of the current member States that prefer a strong currency to a weaker one. It would also create a precedent for a much needed orderly, constitutional, euro exit procedure that could be elaborated for the benefit of countries that prosper more under a relatively weak currency, and would supply an alternative to the unrealistic and preposterous claim of “irreversibility” that is at the root of the present war of secession.

And if some other country then wanted to exit from the Eurozone, it would be for good, fundamental, economic reasons and without creating a political and financial crisis that would jeopardize the rest of the EU.  The survival of a euro and the return of Greece to hope, ending the rampant civil war in the EU, depend on European leaders’ generosity and breadth of vision.  The opportunity is for them to chose.