Greek default: Optimal and suboptimal options – Full analysis

2011-09-20

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A full analysis of the options European leaders are facing, regarding the prospect of a Greek default and their overall approach to the crisis of the euro.

A Greek default will eventually become a reality sooner or later and the euro architecture will continue to fall apart if the same sort of failing delusional fiscal consolidation policies and self-defeating austerity obsessions are exercised (Italy was downgraded today, major French banks had the same fate last week and expect more deterioration and disintegration under the current strategy – or more accurately the lack of strategy). The euro is falling apart and its members are not willing to see that the crisis is systemic and requires system-wide solutions in order to prevent the worse. Instead they continue to treat the crisis as a “debt crisis” of individual states, thus completely ignoring the insolvency of the European banking system and the under-investment that the Eurozone faces (especially the periphery). The latest meeting of Eurozone finance ministers proved once again how united in inanity our leaders are and how they are not willing to accept that they are massively misreading the crisis and have greatly misunderstood its fundamentals (see a rational explanation about the real reasons EU delays a solution to the euro crisis). Now coming to the situation in Greece and the prospect of a Greek default, which I personally believe will not occur in the following weeks since there is no plan to contain the resulting shock wave, which will lead to a financial meltdown greater than that of Lehman Brothers in 2008. I have said time and again that Greece can be -and must be- blamed for all the malignancies of its economy/society/state. Yet this is profoundly different from blaming Greece (and others) for the crisis in Europe, since this constitutes a seriously flawed mode of thinking that ignores the institutional gaps of the euro, the pre-2008 over-leverage of European banks and above all the lack of any stabilizing mechanism that would never allow the trade-deficits of the periphery vis a vis the core to become unsustainable (this can be achieved by means of profitable surplus recycling that would fill in the vacuum). The situation is worsening in Greece. European leaders are facing a number of choices to deal with the events as those unfold.

First the economic reality. Greece will certainly default under the current conditions. Greek GDP massively contracted in 2009 and 2010 and it fell by a further 7.3% in the second quarter of 2011. Unemployment is around 1 million and is projected to exceed 1.2 million, in a population of roughly 11 million people. These are figures that existed in the Great Depression and things get worse as more austerity further contracts the economy and more uncertainty further averts private investment (thus no growth). Greece is in a free fall and there is nothing to stop it, before everything is obliterated. In short Greece is currently facing a serious depression.

So what are the choices European leaders are now left with? To formulate a plan that would contain the catastrophic implications of a Greek default and allow Greece an orderly default and exit from the euro? To maintain the same failing policies hoping that miraculously the situation will change and risk a social uprising in Greece and elsewhere with unpredictable consequences? To change the overall approach of the EU towards the crisis and finally accept that the crisis is systemic and can only be solved with Euro-wide measures, since it is false to view each country separately when all are deeply and inseparably interconnected thanks to the single currency? Let us go through all of them to see the optimal and sub-optimal choices that European leaders have in today’s situation.

A Greek default would have greatly unpleasant consequences for the rest of the Euro area and will lead to the collapse of the euro, since the resulting shockwave will escalate through Italian and Spanish bonds and through speculation that something similar can happen to Portugal and Ireland and will eventually hit French and German banks, leading to a vital need of bailing them out to prevent a total financial meltdown. The latter implies that the public finances of France and Germany will be considerably worsened leading to a downgrade of the credit rating of France and to a worsening of the position of Germany which means that all institutions that rely on Franco-German contributions will also be in a worse position. In short the chain effect will be of such proportions that Germany will prefer to bail itself out of the euro and allow it to collapse and reconstitute the Deutschmark and perhaps seek a new currency union together with some other surplus countries or some neighboring countries like Czech Republic, Slovakia, Poland whose industrial sectors have practically merged with the German.

Assuming that somehow a mega-plan is devised to contain the above calamities, should then Greece be allowed to default and exit the euro? To default (or to restructure debt) yes, but to exit the euro no. An exit from the euro would be catastrophic for the country since Greece will experience hyperinflation, which together with the current depression translates into a grave stagflation. An exit from the euro is going to worsen the crisis in Greece and then there will be a debate about exit from the EU, which is a fundamentally different issue. Let alone the speculation that will be fueled regarding other similar orderly exits of other countries (Ireland, Portugal and others). So a restructuring of debt or default of Greece within the context of the euro and within the framework of a rational plan to contain the effects, is a viable option for our leaders, yet this option is based on the assumption of the existence of a rational plan and such plan does not exist.

The other option is to cling to the same failing policy of using taxpayer money to fund expensive, highly ineffective bailouts to Greece, hoping that somehow the situation will be improved. For me this is a very dangerous political choice and a very irrational economic approach. The economic fallacy lies in the simple fact that in a hardly depressed economy, more austerity only worsens the situation and also in the fact that healthy resources/good money (surplus countries’ taxpayer money) is used in a very unproductive way – it is wasted basically. From the political side this is also an unwise policy since it brews social unrest in the country that has fallen in the austerity vortex, while it spurs well-justified reactions from the citizens/taxpayers in the countries that provide the bailouts. Understandably this option (the one our leaders are exercising) is far from optimal.

The third option, that of a system-wide strategy, is in my view the optimal choice, since it addresses the systemic structure of the crisis and thus puts an end to contagion and the spiraling recession. States are no longer viewed individually (how can they be viewed individually when they in fact constitute the same bloc as is the case today? – this is a tragedy that we are facing). Private banks will no longer act like black holes in the system (we are now heading towards the same situation Japan was, when it allowed its practically insolvent banks to continue their operations by injecting in them liquidity instead of addressing their underlining insolvency). A system wide strategy will address all three dimensions of the current systemic crisis: (a) debt crisis, (b) banking sector crisis, (c) under-investment crisis [for more visit the website of professor Yanis Varoufakis and see his Modest Proposal to deal with the crisis]. This means to formulate a coherent strategy that would:

1. Alleviate the pressure on public finances and end the implementation of self-defeating austerity that is not backed by growth policies, through the issuance of ECB-backed, ECB-guaranteed Eurobonds that will attract surpluses outside of the EU/Eurozone and thus put an end to the policy of channeling taxpayer money into the black holes of the system. Eurobonds will be sold like hot cakes to wealth funds and to other surplus countries and Central Banks.
2. Unify the banking sector and clean it from all the toxic waste it has accumulated (the pre-2008 financial derivatives and the post-2008 sovereign bonds of nearly insolvent states). To do so the EFSF must be given the role of a supervisory banking sector authority that will have the responsibility to carry out objective stress tests (not the sort of exercises in fraudulent accounting that we had these last two years) and will have the power to recapitalize banks in exchange for equity. This is the ideal chance to take advantage of the desperate need private banks have for capital to impose stable rules and allow for restructuring of private debt together with public debt.
3. Mobilize the European Investment Bank (EIB) to act as a much needed surplus recycling mechanism (to counter structural trade deficits and diverging growth rates) in order to massively contribute to economic growth. Growth is the only means of pushing the European cart out of the mud where it has currently stuck. The EIB has twice the funding capacity of the World Bank and can with ease contribute to huge amounts of investment that will create externalities and bring private investment as well thus cutting short the current recession.

At this point I need to underline that what I am writing is based on the current institutional framework and on what is currently available – I am not here to put down idealist theories. Having said that and having put down the options our leaders face regarding the depression in Greece and the overall crisis of the euro, I repeat that for me the change in strategy is the optimal choice to tackle the systemic crisis of the euro and thus also deal with the spiraling depression in Greece and the overall recession in the Euro area.

From the above you may of course consider the orderly Greek default (or debt restructuring) within the context of the euro and within a rational plan to contain its effects as the second-best option. Finally you may accept that the current policy that of maintaining the same failing approach towards Greece and towards the overall crisis, is by far the sub-optimal choice. There can be variances in the technicalities of the possible options but I believe the main ideas are in place. As for those that delude themselves with proposals for the establishment of a fiscal union in the short term to deal with the crisis, I am afraid to say that they fail to evaluate the context of time, the overall social, political and economic dynamics/rigidities and the way EU functions (cumbersome, highly bureaucratic procedures are the main characteristic of the current EU structure either we like it or not).

From the above choices I hope our leaders will choose the optimal (system-wide strategy), but I am afraid they will cling to the sub-optimal or to something even worse they might come up with. These upcoming weeks/months will lead us to a crossroads where the future of the euro will be decided. In this the prospect of a Greek default is a matter of cardinal importance and any decision will decisively shape events. I expect our leaders to take the right path to a better common future.