To Greece and back
In the last month I briefly drifted apart from the eurozone and its problems (amid some interesting graphs), and by doing so I overlooked the Greek default situation. For those who are unsure, Greece did actually default on its debt. After agreeing on the second bailout in February (€130bn) and forcing private holders of Greek debt to accept a larger haircut, in March Greece experienced the largest sovereign-debt restructuring in history (€100bn of its total debt of €350bn will be included in the debt restructuring deal). The debt swap means that current debt holders (mostly EU banks) will exchange their existing debt for new bonds, which pay a lower interest and have a lower face value. This made Moody’s declare that Greece did actually negotiate a default, since that's what a debt swap implies. Another reason why this clearly was a default is that it wasn’t voluntary, as those private holders of debt that didn’t sign up for the bond swap were forced to do so. Anyway, this made Greece open to take in the €130bn bailout, pledging of course to continue with its austere reforms.
The markets seem to have reacted positively to this news, but the story is far from over. This temporary restructuring isn’t likely to do any good to the country if other steps are taken into account.
If you look at the current situation there is no sign of improvement: consumer confidence is hitting a new low, unemployment is reaching a new high, industrial production is still falling as is the manufacturing PMI, while the growth outlook never looked worse. The only two things showing improvement are government gross debt and the budget deficit, both due to the foreign enforced austerity reforms and as a part of the recovery strategy of the Troika (ECB, IMF, EC). Well, as anticipated it doesn't seem the enforced austerity did much help so far.
The program of debt restructuring is that Greece needs to do a whole bunch of austere reforms which aren’t likely to jump start the economy or create a sustainable path for growth. They are expected to decrease their debt-to-GDP ratio from 160% to 120% in 2020, which is still a burden far too heavy for Greece, or anybody for that matter. The 120% threshold is too high, and has no economic justification. It’s a politically chosen goal made up to resemble the current Italian debt-to-GDP ratio, which is still deemed to be sustainable. If this were to be proclaimed too high, Italy would risk further destabilization ignited by ratings decreases and another increase in bond yields. So that's why 120% was chosen, but it is by no means a guarantee of stability. Furthermore, as I noted in October, this set of enforced policy measures will mean that Greece won’t experience any growth or recovery until 2020. It is a lost decade indeed for Greece and a potential danger of a lost generation.
In light of such a catastrophic economic picture, some have called for an immediate exit from the eurozone characterized by currency depreciation and capital controls to stop capital flight out of the country and to quickly restore competitiveness (without the need to renegotiate wages down). However, leaving the eurozone is not an option - the public is against it, and the politicians are overwhelmingly in favour of staying. The costs of leaving are simply too big and no one has the courage or the strength to bear them. The realistic scenario is the one laid out by Blanchard in this text, where the focus will be on reducing debt and the CA deficit in line with trying to restore competitiveness.
But what both approaches omit to realize is that the economy won’t grow based on the mixed and distorted signals it is being subdued into at the moment.
Call for a proper institutional reform
The depreciation argument assumes that the central Greek issue are relative prices not productivity, implying that the depreciation is the quickest possible solution, just like what happened in Iceland. But Greece isn’t Iceland – Greece doesn’t have the productive capacity to be solved simply by currency depreciation. Its culture is consumption (as is shown in its CA deficit structure – see figure 2 on the link), its labour markets are corrosive and state dependent, its state is inefficient (even in basic tasks of collecting revenue), its banking and business sectors are destroyed with lack of confidence and uncertainty. To fight all this Greece doesn’t need a fiscal stimulus and it doesn’t need fake austerity with no institutional support; rather it needs structural reforms and it needs strong pro-market institutions that it seriously lacks.
An institutional reform starts with political stability. The confidence of the Greek people in their government is close to nothing, and who can blame them – every single government so far has left a taste of betrayal. The fundamental principle that the politicians need to restore to address this lack of confidence is belief in the system and its rule of law. The government must act as an enforcer of contracts to signal greater stability to both domestic businesses and foreign investors. After this, it has to continue with public sector reforms and the crucial labour market reform (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process (in which I believe they have gained much experience by now) and create favourable incentives for businesses. The patterns of sustainable trade and specialization can once again be applicable in a slow, yet successful restructuring process Greece desperately needs. This is the only way to enable a productive resource allocation, removed from any distortion signals and able to attract capital. The banking system will follow upon the positive signs of confidence and stability in the economy, reducing capital flight and slowly but gradually improving their balance sheets and preparing more money to foster economic activity.
The euro exit would reverse this process by not allowing political stability to be achieved, and it would take Greece much, much longer to consolidate.
I want to believe that the European policymakers have recognized this, which is why they won’t allow the euro exit, capital controls or a devalued drachma, and call for necessary long overdue reforms, but unfortunately this isn’t the case. European policymakers are slowly beginning to let Greece go (as I anticipated earlier in October), they realize that the danger of Greece pulling with it Spain and Italy is now much less than it was before. They are better equipped now to cope with pressure if such a scenario should occur. But they are also risk-averse and careful in designing a politically optimal strategy as they need to justify to their taxpayers all the bailouts made so far. This is the only thing that's making eurozone leaders still put pressure on Greeks to carry on with debt and deficit reduction and austerity reforms. Even though the current set of policies is clearly backfiring.
Greece should turn to pro-market institutional reforms that will reduce distortive signals in the economy and create scope for market led specialization and investment. This set of institutional reforms isn’t limited only to Greece; they are applicable to a series of countries which found themselves constrained by their existing unsustainable welfare state models of debt accumulation, high CA deficits that were used to finance consumption instead of production, fiscal profligacy, corruption and high levels of state intervention (any country in particular comes to mind? I can think of more than a few).