Since the beginning of the Euro-Zone sovereign debt crisis, talk about the pros and cons of a Greek default and of a Greek exit have been abundant. Economists Nouriel Roubini Rogoff and Feldstein are some of the most prominent standard bearers of the pro default and exit side. Politically, this argument seems to be supported by extreme rightwing parties, such as the True Finns, UKIP and Front National. The opposite view, defended by the European Commission, the ECB and, at least officially, by all EU countries has been defended by several authors. This discussion matters and it is at the forefront of European integration. What happens to Greece will serve as a road-map of what (not) to do in the future.
In the lines below, I discuss this issue in 2 parts. First I consider the arguments for and against default. In order to understand the consequences of such a move, I consider the process underlying such a policy choice. Then I consider the arguments for and against exit. Similarly to before, I then consider the technical mechanisms underlying such a move. Finally, I conclude that outright and disorderly default and an exit from the Euro is not a necessary juxtaposition and that it would bring serious problems to the EU and argue that, while politically not yet possible, a fiscal union is likely top be the best solution.
The table below summarises the different points of view discussed throughout the post:
Arguments in favour of a Sovereign Default
Nouriel Roubini is probably the most famous proponent that Greece should default on its sovereign debt and exit the Euro-Zone. He does a very good job at arguing that case. Here I’ll focus on the default part. The logic is relatively simple and based on accounting. If Greece defaults, its debt is erased. Once this occurs and is digested by the markets, Greece’s debt rating should go up, given that it is no longer burdened by the servicing costs of old debt. This means that it needs to borrow less money, which in principle should make it a better credit risk than it is now. This, in turn should push yields down and allow Greece to pay lower interests on the debt it issues, helping to put it on a more sustainable economic path. It can then decrease fiscal austerity and allow economic growth to take place in this new conjuncture, unburdened by debt. The graphs below, taken from a report on debt restructuring produced by the European Commission, show this:
What are the negative effects of a Greek default?
While the aftermath of the default, as described above, supports the argument in its favour, the issue is more complicated than it would appear. The point with defaults, as with most economic shocks, is whether they are expected or not. If they are, then the shock will be spread over time as actors adjust their investment and consumption choices ahead of the shock itself. If they are not, the whole adjustment occurs at once. In the case of debt markets the main actors are financial institutions and the issue quickly becomes one of how much of the debt is held to maturity or for trading.
Debt held to maturity (HTM) is valued nominally, on the assumption that the contract will be fulfilled. Debt available for sale (AFS) is marked-to-market, on the assumption that it will be sold relatively quickly. Because Greece’s default has been accompanied by a fall in the value of Greek bonds, all the banks holding them as available for sale, will have automatically taken a hit on their balance sheet, because they are marked-to-market. In this sense, having debt contracts accounted for “as available for sale” (AFS) implies that financial institutions automatically adjust to the increased market perception of (sovereign) default. Understanding the consequences of a sovereign default demands the knowledge of how much of the adjustment has already taken place at the time of the default event and so must consider the distribution of debt contracts under each of the two accounts above.
Clearly, investment banks, hedge funds and derivative companies should hold these assets on a AFS basis, while pension funds and insurance companies probably hold them to maturity. Depending on the size of each of these sectors the shock will be more or less expected. However, financial institutions holding Greek debt, unwilling to decrease their balance sheets, decided to transfer the sovereign bonds to a AFS account. As such, it is very likely that a Greek default would come as an accounting surprise, which would imply a higher shock as the balance sheets would decrease at once rather than progressively. This would imply a large shock to liquidity, putting pressure on the EONIA, on the credit conditions faced by consumers and SMEs and of course on the balance sheet of pension and insurance companies.
On a more positive note, the fact that banks have started to account for the falls due to regulatory pressure and to the Greek restructure is a good thing, to the extent that it provides for that progressive adjustment that mitigates the impact of the liquidity shock.
Should Greece really Default?
For the reasons described above, it is my opinion that a Greek one-off default would be a very bad thing. To this extent the derided distinction between restructure and default matters quite a lot, as it implies a more progressive adjustment, which is desirable. Indeed, a restructure of Greek debt is a more favourable choice. Not only does it imply a smaller, more manageable liquidity shock, it also implies a degree of control by authorities, which are able to handle the situation better because of this slow pace of adjustment. This is somewhat similar what Anne Sibert discussion of orderly default in her report to the European Parliament. Finally, there are default considerations that affect the ECB. A default by the Greek sovereign is bound to affect it. In this sense the creeping transfer union operated via the TARGET2 system is a considerable logistical problem to Greece leaving the Euro.
Processes underlying Sovereign Debt Restructure
The recent PSI requirement of the second adjustment programme for Greece provide a good guide to several steps of sovereign retructuring. As far as I can see, there were 6 steps:
EXITING THE EURO-ZONE
While the idea of a Greek default has always loomed in the background of discussions of the Euro-Zone crisis, it was regularly accompanied by the idea of an exit from the euro-zone. This idea gained traction from October 31 onwards, when the then Greek Prime Minister, Papandreou, announced his intention to hold a referendum on the second bail-out programme for Greece. This was promptly understood as a call for a referendum on membership of the Euro. The arguments in favour of a Greek exit of the Euro-zone are relatively simple and overwhelmingly concerned with the positive effects that the accompanying devaluation would have on trade. The extent to which this is a complete picture is, in my view, very dubious.
Arguments in favour Greece exiting the Euro-Zone
There are several proponents in favour of this view. Several top Danish economists have argued that Greece should and will leave the Euro-zone. Martin Feldstein endorses the view that Greece ought to take a temporary leave of absence from the Euro. He elaborated on these views in a later interview with Deutsche Welle. Kenneth Rogoff also believes that this would be the best course of action because the euro-zone is not “a system in equilibrium”. As stated before, Nouriel Roubini also holds the same view. Even Arianna Huffington has weighted on this issue in favour of an exit.
The argument for an exit is based on the desiquilibrium that Rogoff describes, which is a reference to the inconsistencies of the Euro-zone as viewed from the point of view of the Optimum Currency Area (OCA) theory. In short, a monetary union without fiscal union, implies a limited adjustment during asymmetric shocks, which reinforces economic divergences. While it is common to hear that labour mobility and wage as well as price flexibility would assist in dealing with this problem, that is not exactly true. What these “efficiencies” do is to facilitate a macroeconomic equilibrium where aggregate demand meets aggregate supply. However, these flexibilities only allow the market to clear at a higher level for the country not affected by the shock and at a lower level in the country affected by the shock. Flexible product and labour markets only facilitate the equilibrium of divergence, they do not impede it. The only tool that can stop this divergence is a fiscal union that transfers the benefits of the asymmetric shock in the surplus not affected country to the affected deficit country.
Of course, there is still an OCA argument against membership of the Euro-Zone. Because it is only a monetary union, it is an incomplete union, the members of which are likely to experience economic divergence rather than convergence. In principle, the exiting country, a master of its new currency would be able to lower interest rates, depreciate its currency and facilitate a more complete adjustment, at higher levels of GDP and with less deflation.
Mechanisms involved in a Greek exit
The previous discussion assumes that exiting the Euro-zone is only a matter of changing the symbol on the bills and coins. The ensuing discussion shows that legally and logistically this is not as simple.
The Law: Any discussion such as this should begin by considering the legal feasibility of such a policy choice. Phoebus Athanassiou’s article, published by the ECB, is the main source for any legal considerations about withdrawal and expulsion from the EU and EMU. While economists and politicians like to think they can ignore the law, they cannot, so this matters a great deal. His conclusion, in light of the existing treaty law, is that:
- No country can be expelled from the Euro-Zone.
- Any voluntary exit requires a country to also exit the EU.
The Logistics: Back in 2010 Barry Eichengreen wrote extensively about the practical implications and difficulties of this scenario. While the insights are general, their relevance for Greece is obvious. Here I focus on his last argument that
” Computers will have to be reprogrammed. Vending machines will have to be modified. Payment machines will have to be serviced to prevent motorists from being trapped in subterranean parking garages. Notes and coins will have to be positioned around the country. One need only recall the extensive planning that preceded the introduction of the physical euro.”
Other technical issues are described by Blejer and Yeyati 2010, use the Argentinian default as a template for future ones. The authors argue that:
“If a country is willing to seriously entertain the idea of introducing a new, weaker, currency (which for simplicity we could call the peso), it needs to be willing to deal with:
- the “peso-ification” of contracts,
- the imposition of heavy restrictions to commercial bank operations,
- an external debt restructuring, and
- the use of capital and exchange controls – at least temporarily.”
On the topic of debt contracts “peso-isation” Returning to the problems posed by the TARGET2 payment system, Anders Aslund rightfully reminds us that the ECB is one of the most exposed holders of Greek sovereign debt. If Greece should exit the Euro-Zone, the devaluation of the new currency would imply a shock to the ECB’s balance sheet, smaller but similar to the one caused by a default. This is a logistical problem that must be addressed as well.
All of these issues are legally, economically and socially difficult ones to deal with.
Greece should stay in the Euro-Zone
While several commentators have argued against exiting the Euro-Zone, Willem Buiter is probably one of the most prominent standard bearers of this argument and of “the terrible consequences of a Eurozone collapse“. Larry Summers recently argued, in relation to the second greek bailout, saying that the “Greek aid deal [is] ‘much better’ than Euro exit“. Buiter’s argument rests heavily on the legal and logistical complexities described above and on the assumption that the exit would be disorderly. As he puts it,
Following the exit, contracts and financial instruments written under foreign law would likely remain euro-denominated. Balance sheets would become unbalanced and widespread default, insolvency and bankruptcy would result. Greek output would collapse. Greece would temporarily gain a competitive advantage from the sharp decline in the new Drachma’s value, but like Portugal, Spain and Italy, Greece does not have the persistent nominal rigidities to make it a lasting competitive advantage. Soaring wage and price inflation would restore the uncompetitive status quo. Without external funding, imports would collapse, disrupting domestic production. Aggregate demand and aggregate supply would chase each other downwards. (…) Exit contagion might sweep right through the rest of the eurozone periphery – Portugal, Ireland, Spain and Italy – and then begin to infect the “soft core”of Belgium, Austria and France.(…) [A] disorderly sovereign default and eurozone exit by Italy would bring down much of the European banking sector.
While the redenomination of contracts in the new devalued currency has the same liquidity destruction effect as a default, the exit scenario has the added negative macroeconomic effects described above. Clearly, a Greek exit would not end the Euro, as Commissioner Kroes puts it, but it would create a lot of problems
The View from Place du Luxembourg
This website subscribes to the view that an exit from the Euro-Zone is a bad idea, not just for Greece but also for the other 17 countries. However, the following discussion extends this argument a little bit further by offering a 5 part counter-argument to the proponents of the exit scenario, as well as some further comments about the default-cum-exit logic.
- While it is acknowledged that, ignoring logistical details, exit is a solution to the OCA divergences, it is not the only one. Clearly a fiscal union that offers the transfers described above would achieve the same convergence role. This is not a perfect solution. Proponents of exit would correctly argue (i)that at present, this is not a politically feasible path. Moreover, (ii) such a union incurs the risk of creating a dependency culture where the core finances the rigidities, inefficiencies and general lack of competitiveness that plague the periphery, thus fomenting divergence. This brings me to my two other points.
- The argument over the political feasibility of a fiscal union is a very legitimate one. Such an agreement would have to be endorsed by the whole of the EU, not just the EMU members. Veto player theory rightly implies that the likelihood of 27 member states reaching such an agreement is not large. However, the same logic also shed a similarly dark cloud over a monetary union, and it still happened. More importantly, the rhetoric of European leaders as well as the reforms they have started point more in that direction that in the direction of exit.
- In my view, the argument that a fiscal union would create fiscal dependencies and reinforce the periphery’s lack of competitiveness suffers from a crucial fallacy. It presumes that competitiveness would return to the periphery after exit. I believe that this is unlikely to happen, for several reasons:
- First, as described by Buiter above, the devaluation would probably create wage and price pressures that would be likely to lead to inflation. This would lead to lower competitiveness, rather than higher. The present EMU arrangement, while by no measure complete, provides credible commitments to low inflation. Moreover, Putnam’s two-level game considerations also complement this picture quite well. Indeed, it is not just that the ECB is staunchly conservative and reactive to inflation. In principle, because the EU demands good governance this means that a government seeking low deficits would have an easier time selling it to its population and one unwilling to do it would be pressured to do it.
- Secondly, the argument for exit is based on the assumption that Greece would suddenly be well governed and run low deficits. With all due respect to the Greeks, who are not necessarily responsible, the last 150 years of economic and political history suggests that their political institutions are quite poor. Their own perception, according to Transparency International is that corruption pervades their society. On the contrary, it is very likely that aside from the pressures described by Putnam’s 2-level game, the monitoring tools devised by the EU since the inception of the crisis will, if credible, provide a strong tool against the moral hazard that pervades Greek political institutions. While the figure below, mapped from data compilled by the European Commission, might imply that Greece has reformed its institutions a lot, it should be highlighted that the majority of these reforms have been carried out in order to enter the Euro-Zone. Without the Euro-Zone to monitor, punish and reward Greece, and with a very centralised political system, moral hazard will ensure that an unsustainable fiscal path is followed. Although Barroso is probably exaggerating the risk, it is not completely unthinkable to consider that such a move could actually lead to a complete democratic meltdown, particularly if we consider how European integration is a driver of democratisation. Whether the direction of causation can work both ways, is unknown.
- Competitiveness is not only dependent on labour costs and exchange rates. It is a measure that weights value added, as measured by the price of the finished product against labour costs. As Felipe and Kumar show, the problem is not that wages are high, but that the product markets in which the periphery has specialized are unsophisticated and have low value added. Indeed, Germans work much fewer hours than the Greeks, Italians, Portuguese or the Spaniards. In more ways than one, the periphery is competing with China more than with Germany. Should EU citizens be paid Chinese wages? (for that sake should the Chinese?…) Oddly that seems to be the present trend…
- It is also worth mentioning that heterogeneity is a normal fact of economic unions. This was a point highlighted by Jean-Claude Trichet, who showed that Unit Labour Costs in the EU were less dispersed than in the USA. Not everybody can run a budget surplus.
- Finally, any exit from, or breakup of, the Euro-Zone fails to address the problem which the Euro solved: exchange rate volatility. This problem which arose with the end of the Bretton Woods system and the political tensions it created were the main causes for the creation of the Euro in the first stage. The dissolution of the Euro would replace new problems by old ones, without necessarily providing any solutions.
Finally, Place du Luxembourg is somewhat confused by the association that is often made that a default necessarily implies an exit. This is not necessarily so. This would only make sense if the positive effects of one were conditional on the presence of the second. Clearly, such a connection is never made. The logic behind it is that if a default would help, a default and an exit would help even more. Having shown that neither helps much it seems legitimate to dismiss either or both.
CONCLUSION: Disorderly Default and Exit are a Terrible idea
This post has discussed the pros and cons of default and exit. While restructure, total (default) or partial (haircuts/swaps) is likely and ongoing, it is fundamental that it should happen in an orderly manner and over as long a period of time as possible. However, exit, in any form would probably fail to deliver the promises of competitiveness and stability that its proponents propose. This is because the argument for exiting the Euro fails to consider the technicalities involved in the exit process and either ignores or overstates the likelihood of good governance in the post-exit period. In spite of the apparent pro-active intervention of the ECB in Italy and Spain, the argument for exit also probably understates the contagion risks in the Euro-Zone.
The only long term solution is a Fiscal Union. This would solve the asymmetric shock problems of the Euro-zone by redistributing the benefits of that shock to the core to the periphery. However, such a union must be well devised and well campaigned for. How this can be achieved should be the foremost concern of EU leaders.
The arguments in favour of a Greek exit of the Euro-zone are relatively simple and overwhelmingly based on perceived parallels with the Argentinian experience with restructure and repesoification. Blejer and Yeyati provide a good description of the relevant steps involved in this process.