Monday, November 24, 2014

Greece Must Exit

NEW YORK – The Greek euro tragedy is reaching its final act: it is clear that either this year or next, Greece is highly likely to default on its debt and exit the eurozone.

Postponing the exit after the June election with a new government committed to a variant of the same failed policies (recessionary austerity and structural reforms) will not restore growth and competitiveness. Greece is stuck in a vicious cycle of insolvency, lost competitiveness, external deficits, and ever-deepening depression. The only way to stop it is to begin an orderly default and exit, coordinated and financed by the European Central Bank, the European Commission, and the International Monetary Fund (the “Troika”), that minimizes collateral damage to Greece and the rest of the eurozone.

Greece’s recent financing package, overseen by the Troika, gave the country much less debt relief than it needed. But, even with significantly more public-debt relief, Greece could not return to growth without rapidly restoring competitiveness. And, without a return to growth, its debt burden will remain unsustainable. But all of the options that might restore competitiveness require real currency depreciation.

The first option, a sharp weakening of the euro, is unlikely, as Germany is strong and the ECB is not aggressively easing monetary policy. A rapid reduction in unit labor costs, through structural reforms that increased productivity growth in excess of wages, is just as unlikely. It took Germany ten years to restore its competitiveness this way; Greece cannot remain in a depression for a decade. Likewise, a rapid deflation in prices and wages, known as an “internal devaluation,” would lead to five years of ever-deepening depression.

If none of those three options is feasible, the only path left is to leave the eurozone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth.

Of course, the process would be traumatic – and not just for Greece. The most significant problem would be capital losses for core eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks, and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it “pesofied” its dollar debts. The United States did something similar in 1933, when it depreciated the dollar by 69% and abandoned the gold standard. A similar “drachmatization” of euro debts would be necessary and unavoidable.

Losses that eurozone banks would suffer would be manageable if the banks were properly and aggressively recapitalized. Avoiding a post-exit implosion of the Greek banking system, however, might require temporary measures, such as bank holidays and capital controls, to prevent a disorderly run on deposits. The European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) should carry out the necessary recapitalization of the Greek banks via direct capital injections. European taxpayers would effectively take over the Greek banking system, but this would be partial compensation for the losses imposed on creditors by drachmatization.

Greece would also have to restructure and reduce its public debt again. The Troika’s claims on Greece need not be reduced in face value, but their maturity would have to be lengthened by another decade, and the interest on it reduced. Further haircuts on private claims would also be needed, starting with a moratorium on interest payments.

Some argue that Greece’s real GDP would be much lower in an exit scenario than it would be during the hard slog of deflation. But that is logically flawed: even with deflation, real purchasing power would fall, and the real value of debts would rise (debt deflation), as the real depreciation occurs. More importantly, the exit path would restore growth right away, via nominal and real depreciation, avoiding a decade-long depression. And trade losses imposed on the eurozone by the drachma depreciation would be modest, given that Greece accounts for only 2% of eurozone GDP.

Reintroducing the drachma risks exchange-rate depreciation in excess of what is necessary to restore competitiveness, which would be inflationary and impose greater losses on drachmatized external debts. To minimize that risk, the Troika reserves currently devoted to the Greek bailout should be used to limit exchange-rate overshooting; capital controls would help, too.

Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial. Other peripheral countries already have Greek-style problems of debt sustainability and eroded competitiveness. Portugal, for example, may eventually have to restructure its debt and exit the euro. Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, without such liquidity support, a self-fulfilling run on Italian and Spanish public debt is likely.

The substantial new official resources of the IMF and ESM – and ECB liquidity – could then be used to ring-fence these countries, and banks elsewhere in the eurozone’s troubled periphery. Regardless of what Greece does, eurozone banks now need to be rapidly recapitalized, which requires a new EU-wide program of direct capital injections.

The experience of Iceland and many emerging markets over the past 20 years shows that nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness, and growth. As in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.

Like a doomed marriage, it is better to have rules for the inevitable divorce that make separation less costly to both sides. Make no mistake: an orderly euro exit by Greece implies significant economic pain. But watching the slow, disorderly implosion of the Greek economy and society would be much worse.

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    1. CommentedJoe Banderson

      I know this was written a while ago, but I just found it and would like to post a question.

      People seem to always talk as though there are only two options for Greece. It will need to go through either an orderly or disorderly default.

      Has anyone considered that the ECB would rather try to pigeon-hole Greece, and perhaps other PIIGS nations into giving up their sovereignty altogether in order to take the first steps toward a United States or Europe (for lack of a better term). After all, the most powerful men in the world are those who control money (read Central Banks and related parties) and it would be far simpler for them to wield power in Europe if it were to adopt more centralized system of government.

    2. CommentedGary Marshall

      Here is a solution to the Greek problem. If anyone can find the flaw, I shall be more than happy to give him or her $50,000. I am just tired of doing this.


      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by
      simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any
      more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

        CommentedGary Marshall

        Hello Jimmy,

        I am not an economist either. And carpenters can be pretty formidable people given their knowledge of construction materials, math, designs, planning, finance, costs and benefits, etc.

        You ask the right questions.

        There are few entities on this earth that do not count liabilities among their assets. Most of us carry debts and many other liabilities. That is not the worrying part. The part for concern is the value of our assets. Do one possess assets exceeding those aggregate liabilities. Most will say yes. Some no.

        Does a government possess financial and material resources? Certainly. With Taxation, the combined financial and material resources of every entity within the nation. Without Taxation and with borrowing, the same. This is what backs the nation's financial debts.

        Now if an entity can borrow and invest, creating assets that exceed liabilities, should it do so? The answer is obvious, and just as obvious if it cannot.

        So if a nation can borrow from itself, its citizens, and create assets that exceed the acquired liabilities, should it do so? Yes.

        Banks do it all the time. They borrow from one and invest or loan money to another, living on the margins. They never pay off their lenders. They just borrow more money for supplying more loans, creating assets that exceed liabilities.

        And it will be the same for a nation. Borrow from one and invest in some project, creating assets that exceed liabilities and enriching the nation and its people. An investment in clean drinking water will take out many water borne diseases that drive up medical costs and reduce the working days of a labourer.

        The piece above merely shows that the cost of borrowing for a nation is in effect nil. The debt obligations issued by a nation create a liability that is equally matched with a created asset, held by a resident US lender.

        Its like a bank adding to both sides of its balance sheet. The addition of an asset offsets or nullifies the addition of equal extent of a liability. Or in other words, are you better off if you borrow $1 from your mother? You owe what you now possess, so your circumstances are unchanged.

        The question for the Government now centers on what we get for our money expended in public projects? With Taxation, there is no justification because government can take your money and do pretty much as it pleases. With borrowing, the government will have to approach the citizen and provide a proper analysis.

        The amounts borrowed will be so large, that no one person or entity could ever exert noticeable control over a nation. It will be a far different story from the present one.

        Why would the government help the poor? Why do they help them now? Unfortunately, the poor have many problems. That is why they can't make a go of it on their own. The state say gives a family $12000 per year. What is the amount of an annuity that will yield $12000 per year?

        Whatever the value, it is the true liability to the nation of a family in need of assistance. Why not offer the household a loan to enable a person to go to school for training for a far better job? With the job obtained, the family can pay back the loan.

        Is that not a fit place to live in?

        You speak of a subvention to a circus troop. Wonderful thing. How much more money would be available for such things if the government execs actually cleaned up the construction and road clearing contracts that always go to the favoured, for a high price and a hell of a kickback no doubt?

        When the state has to borrow, that kind of corruption will quickly come to an end.


        Commentedjimmy rousseau

        I am just a carpenter and not an economist, but when i hear "the nation does not pay off it's debts" something sounds wrong. Am i to assume that the lure of making a profit on the loans is the only way the government can raise funds? Does this mean that only the people with capital to invest will have a say in how the government spends? Why would the government help the poor? If government has to justify a financial benefit it seems to me our society will not be a fit place to live.
        revolutionary ideas like these remind me of when someone on a job site has a great idea to do something totally different. Sometimes the ideas are fruitful but often people discount the generations of experience that have gone into the present system and the new idea eventually runs into plenty of problems down the road. problems that had been solved a long time ago and that you don't even think about because our framing system has become automatic.
        I live in canada and i think about a government subvention 30 years ago to a ridiculous little circus troop in quebec city. I am sure without these subventions they would not have survived and the subventions were given on artistic merit rather than financial. Today cirque du soleil and it's employees have payed many, many times more in taxes than that original subvention. This is a very complicated subject and we must refrain from simplistic solutions.

        CommentedGary Marshall

        Hello Jimmy,

        The nation does not pay off the debt. Its sort of like a bank. The assets and liabilities rise, the former always outpacing the latter. One would of course pay off the individual lender, by substituting another lender. This is called success in the banking system, and it should be in public finance as well.

        This is primarily a funding issue, not an expenditure issue. I am only concerned here how we fill up the government's money bag, not how we empty it. The expenditures will continue as normal, but with a profound difference. As the funds will thence come with a financial cost, they will have to generate a justifiable financial benefit for the nation or jurisdiction. Cost and benefit analysis in government expenditure. Its the way of the future.

        I do agree the government is a group of people. So a government's financial resources are in fact the combined financial assets of that group. In order to better understand public finance, one is going to have to concentrate upon the health of that group's finances, which is in effect the government's.

        One could institute certain user fees, but generally to discourage abuse of public resources rather than bona fide use of them.

        Any other objections?

        Gary Marshall

        Commentedjimmy rousseau

        Another business oriented model trying to superimpose itself on a public service reality. When you take that 10 million to pay your police force how are you going to pay off the debt. Will you try to make it a user-pay service, will this work for the military. At the end of the day a government is a group of people getting together and pooling their money to procure something they need, a stable society, roads, security, etc. Any other easy questions?

    3. CommentedTorrens Hume

      During the depression, many jurisdictions in the US and in Europe used scrip to escape the shackles of a common currency. Some of these were effectively depreciating currencies. Harold James has suggested that these experiments could be a means for exit by peripheral countries in Europe.
      Essentially, the idea is to allow the economy in question to remain euroised while slowly introducing a new currency that would eventually allow either an exit (or if any country was foolish enough, a re-entry). Key elements are laid out here:

      The key right now though, and this applies not only to an exit but to th rest of the euro institutions is to lay down rules that eliminate the uncertainty around the processes tha tgovern the unthinkable. That is one of the things that public policy does. It provides guidance on how to deal with imperfections in the eocnomy --such as how to define property rights in a divorce. Right now, as is concluded here, that guidance is urgently needed.

    4. CommentedH Gerken

      There is a crisis of political trust and the weak negotiations of Germany in the setup of the Euro now bounce back. The crisis is a chance for getting the regulatory garden in order. But such rules are bullied by irresponsible politicians as a German takeover. The way out is sound governance. Furthermore on the international scene it is important to make an ordoliberal shift. Financial liberalisation paved the way for the crisis. Commissioner Barnier has now the task to make way for tighter rules and integration. Hollande and Merkel represent two sides of the same coin.

    5. CommentedGeorg Tillner

      Mr. Roubini's argument rests on the assumption that a return to a national currency would "quickly restore competitiveness and growth". Competitiveness in what markets? What industries? I think we should question the validity of this economic truism, at least in the case of the present Greek situation. I fear this assumption is just another simple-solution hope in a long sequence since 2010; shouldn't we rather face the even bleaker reality that there is no single solution?

    6. CommentedAndrew Purdy

      If Greece is going to leave the Eurozone, why should they pay the Troika anything? As soon as the Troika's money spigot is turned off, Greece should repudiate all of its external debts, and be prepared to have external trade only to the extent it can be done in US Dollars.

    7. CommentedGeorge H

      I don't think Greece must exit the Euro, rather it may exit the Euro. I strongly believe it is in Greece's interest to stay in the Euro.

      Greece has no resources to support it in a devaluation exercise. Companies would still have to import raw material and foreign suppliers will not accept payment in Drachma.

      The benefit of a devaluation that local companies will have is only to the labor rates, which do not constitute a significant portion of their cost structure. Moreover, if a return to drachma and a devaluation does occur, a big portion of the qualified labor force (especially the young labor force) will actually leave the country for better working conditions in Germany / UK. Competitiveness will not be restored by a devaluation.

      Inevitably, regardless of the path, I think Greece will face a massive GDP deflation accompanied with a strong out-flux of its labor population. The economy will inevitably get smaller and would be on the life-line of the other European economies.

      My solution however is a subsidized environment supported by Germany and Greece (and maybe others), giving incentives for German companies to increase activity (production / assembly lines / etc...) in Greece. This will allow the local labor force to remain in Greece and slowly regain competitiveness and know-how. The benefit is both ways, German companies will expand (rightfully so!) and Greece economy will expand.

        CommentedDavid Joseph Deutch

        Germany is evidently not willing to undertake any such endeavour.

        Greece will indeed incur a huge decrease in GDP but at least if they regain control of their monetary policy, they can dictate the terms of their economic recovery rather than have austerity handed to them by Germany.

    8. CommentedWilliam Wallace

      The euro remains a political currency unbacked by a fully integrated market (nation-state equivalent). With loosely connected fiscal policies among member states, no automatic offset of slower growth regions via internal social spending transfers, and very low labor mobility due to language and remaining legal barriers, the only way such a currency makes sense is if it is shared among otherwise highly similar economies.

      Southern European countries should not have been part of the initial euro launch, with the possible exception of Italy. Spain, in particular, saw its competitiveness massively erode after the highly inflationary introduction of the euro, and the inflow of excess cheap (at the time) capital. Given a decade or two post-euro to consolidate growth and mature, Spain's later and successful entry into the euro would have been highly likely.

      Given the fundamental weakness of the euro as a hybrid currency, and the mistakes made prior to and following its launch, it may very well be the case that the euro itself requires a Greek exit. As for the Hellenic tragedy playing out now, the only dramatic turnaround scenario does seem to be that of exit and devaluation.

    9. CommentedPaul A. Myers

      The benefits and costs of a currency union need to be widely shared, not necessarily equally shared.

    10. CommentedFrank O'Callaghan

      Is this 'marriage' doomed? The benefits of the currency union are not equally shared. Nor are the costs.

      Couching the crisis (primarily) in terms of competitiveness may obscure fundamental issues.

    11. CommentedMike Muller

      This is a well-thought best solution given the constraints imposed on Greece and Europe.

      The previous commentators prefer that Greece stays in the Euro, given the feasibility of its salvation by Europe because of its small GDP share, or because cultural deficiencies prevent nominal-devaluation-driven growth.

      They are wrong and Roubini is right. Even though Greece makes up for only 2.5% of Europe GDP, Greece cannot be subsidized out of its depression. It has to recover a sovereign status and growth via nominal devaluation with its own currency. The cultural objection to Roubini´s scheme does not stand either. Growth and competitiveness will be quickly and automatically restored by a nominal devaluation on a sovereign currency. No need for cultural changes. The latter are probably necessary in the mid- to long-term. But right now, this year and next, the only solution is a scheme pretty much similar if not identical to the one proposed by Roubini.

      The only additional thing that might be worth mentioning is that the most likely winner of next elections, Mr. Tsipras, knows all this and is promising a package consisting of staying in the euro and re-negotiating the terms of the bailout merely to anesthetize the electorate until he gets into power. When that is achieved, Roubini´s scheme or some close variation will soon be effected.

      Greece can base a growth policy after exiting the euro on shipping and tourism, as well as food-related industries. Tourism is a major industry in Europe. It has all by itself sustained the much larger Spanish economy during the crisis years. With some investment in the roads and other public spaces in coastal areas (which are obviously a little run down) the tourist offer will improve substantially in quality. Greece has the largest merchant navy of the world. Its insular geography may allow further development of fishing and aquaculture. Greece is currently the largest aquaculture finfish producer in Europe. though most of its exports in this industry go to Spain and Italy. The option of diversifying to northern Europe is there, the potential is there.

      Greece just need an opportunity to become a monetary sovereign. It has to default and start to build up with its resources. Thanks to Roubini for a piece that has looked at all the important aspects of Greece's situation and the way out.

    12. CommentedPaul A. Myers

      The centerpiece of Roubini's argument is: "The only way to stop it is to begin an orderly default and exit." Only way? That's nonsense.

      Greece makes up 2.5 percent of the European Union. If there was ever a situation ripe for "Can Do" leadership, it is here. The Europeans are going to let themselves come undone over 2.5 percent? This is an upside problem awaiting solution, not a cataclysm waiting to happen.

      Roubini's criticism of the Troika is spot on. But the Troika is correctable. The Troika is just trying to refinance yesterday's mistakes, not create tomorrow's solution. That is a typical knee jerk solution by an elite.

      The European Union can keep the Greek government going, the European Union can keep the deposits in Greek banks safe, and the European Union can negotiate a true financial package that will stabilize the patient, reduce risk, and move the Greeks towards something looking like growth. Europe can do this.

      And the only way to ring fence the problem is to ring fence Europe with an integrated, soundly financed national-style economy. Time for some tougher politics, an unflinching look at what it takes to grow in the world economy. And you take the walking wounded with you when you march!

      What's the real cost? Well, yes, we will have to blow away a few more elected leaders. But we have already made good progress on that score. But that is why democratic government works. Leaders are replaceable.

      The people of Greece are right. Eighty percent want to stay with the euro. That's the right answer. They want a new deal. That's also the correct answer. Why get things wrong when the people are so right?

    13. CommentedAndreas Gandolfo

      In the past, I have repeatedly pondered the idea posed here by this article. That Greece should have exited the Euro from day one, introduced a new currency, and go on with restoring competitiveness in an "automatic" way, imposed by the markets. I even thought sometimes that Greece could have negotiated a plan under which temporary exit was considered. A set of targets could be set up, within a time frame (5-10 years), under which the Euro countries "took care" of Greece's Euro debts today (some defaulting, and other being paid by them) in exchange for a grace period which would turn Greece into a debt free country. Then, with the power of devaluation, the economy could be turned to exports, the state reformed, the taxation system improved, the private sector would flourish, and the public sector would be left with the few things it can only do.

      Unfortunately for Greece this is not a possibility. At least not today. The politics (and mentality) of the country would not allow for the right changes to occur. And without a big mining industry, and an oil industry, the state would fail to find the funds that Argentina found to go on without change (cause its economy is plagued with the same problems of 2001 and its desperate moves of nationalization and thirst for cash, along with 20% inflation are clear signals of that). Thus, the Greek state would recede and die, exposing Greece to internal rife. It would turn very quickly into a failed state, resembling the collapsing soviet countries at the end of the USSR. Oligarchs would snatch up dirt cheap enterprises sold off to satisfy the peoples want for easy cash. When that would be over, the lack of money would either force printing, or a startling realization of the truth, that everything needs to be rebuilt. The economic suggestions proposed in here would fail not because of a theoretical flaw. They would fail because they need strong and inspiring politics to be applied, something that Greece lacks. With its devilization of entrepreneurship, its ardent nationalism, its pampered citizens, and its inability to plan for the true long term, Greece would enter a phase that would resemble Russia's first years after the collapse of the USSR at best, and African failed states at worse. On top of that, the waking up would take a long time. Greek politics (and the masses following) would start playing a blame game for why everything is collapsing (something going on already). Instead of entering a correcting path, Greece would try to go back to a state that rewards its public workers for showing up at work, and choke off private enterprise by mingling in everyday life.

      I would be the first to suggest an organized euro exit for Greece should I have seen a true dream of creating something better out of it. But since all I see is more, and more, and more destruction, staying in the Euro seems to be the only option holding us back from oblivion. I know it is sad to see good economic ideas fail because of politics, but as a Greek myself, I have to say that this would be the case for my country. And before anyone says that politics hinders economics everywhere, I want to warn them that I have seen political obstacles of different sizes, and Greece's case is one of those that are so deeply rooted, that few tools can remove them. The hope to stay in the Euro, today, seems to be one of those powers, lets not take that beneficiary force away.