The siren song of default


Homer’s Odyssey is the epic account of the ten year journey of Odysseus back to his kingdom of Ithaca after the Greek victory in the Trojan War.  Odysseus had conceived the wooden horse trickery that won the war for the Greeks.  But the impiety and unrestrained cruelty of the Greeks in their sack of Troy angered the Gods who decided that most of the Greeks would be doomed to never return home.

Odysseus, who was favoured by the goddess Athena, was allowed to return home.  On that long trip his ship passed the Sirens who sang a beautiful song to lure sailors onto the rocks.  Odysseus plugged his sailor’s ears with bees wax.  But he wished to hear the song, so he had his sailors lash him to the mast for the duration of the journey past the sirens.  Greece’s membership of the Euro has it lashed to mast even as it passes the Sirens who sing out “Default, default.”

Let’s say that the Greek Government did suddenly announce a total default on all its debt.  What would follow?

We can say for certain that the Greek Government would have to nationalise the Greek banking system, leave the Euro and reinstate a national currency (let’s call it the Drachma) and convert all bank liabilities and assets from euro to the Drachma denomination.  

Greek banks own 70 billion euros of Greek Government debt, which is twice their total equity capital.  Therefore, as soon a the Greek Government defaulted the banks would be insolvent and there would be a massive run by depositors to get their euro denominated deposits out.  The banks would turn to the ECB for liquidity to meet the deposit withdrawals, but their Greek Government debt could no longer be used as collateral, so the ECB would turn them away.

The Greek Government would be forced to close the banks and only reopen them once all assets and liabilities had been converted into drachmas.  The Government having regained control of its currency would be able to provide liquidity to the banking system, print money and devalue the currency.

There would most likely be considerable public disorder.  Imagine how furious families who had their life savings in euros would be after they were converted into drachmas.  Moreover, the legality of turning Greek euro bank debts into drachma debt would be contested in the European courts.  French banks, which have nearly 35 billion of lending to Greek banks would not accept the conversion of those assets into Drachma denomination without a lengthy legal contest.  If Greece ignored rulings by the European courts then its very place in the European Union would be bought into question.

The reform process in Greece would, of course, be completely unwound.  But the worst thing might be the effect on Greek confidence.  Consumer and business confidence would plummet, which along with financial uncertainty, civil disorder and rising inflation, it would send Greece into much worse depression than it is experiencing at the moment.

I think that Greece is on the right track for now.  Most likely there will be a slow and orderly default on Greece’s sovereign debt in the future.  But a sudden default now would be disaster.


5 Responses to "The siren song of default"
  1. Greece cannot repay its debts by increasing its debt and reducing its output. The bailout will not work unless there is a plan to increase Greek productivity and wealth.  You do not do that by austerity measures. You do that through investment and a redirection of resources.  What is required is an investment program but where the investment creates Greek wealth not debt. Greece requires ways to increase investment and build up assets – not run them down or sell them.

  2. “If Greece ignored .. the European courts then its very place in the European Union would be bought into question.” I think you are correct that default would mean withdrawing from the Euro which would also mean leaving the union. Would that be such a terrible thing compared to their current situation – endless austerity measures with no end in sight?
    The problem is that the current debt can never be realistically paid off. When individuals are in that much debt, they declare bankruptcy or negotiate a deal with their creditors. Could Greece threaten to default and leave the union, unless say 75% of their debt is written off? Is it not actually good for the financial system for banks that lend to insolvent governments learn to take their loss, rather than ask the country to live in perpetual penury?

  3. The Greek really are between a rock and hard place (a metaphor not as lyrical as The Odyssey, though Odysseus did have to enter Hades – a good substitute for the international bond market.)
    A threat to default and leave the monetary union is not that credible. A 50% – much less 75% – haircut on their creditors would probably smash Greek bank equity with debts denominated in Euros. It would fall on a barely competent government to then bail out the depositors – assuming they don’t take the money and run earlier (thus precipitating a banking crisis prior to default).
    It took about two years of preparation and implementation for well-run European governments to enter into monetary union; Greece certainly didn’t achieve that and I doubt they could manage to get out as quickly as they need to even under circumstances of desperation.
    Even going back to a heavily devalued drachma may not help much. The private sector is not productive relative to the rest of Europe (e.g. rent-seeking behaviors and the like). Exports are less than 10% of GDP so they can’t really trade their way out of trouble. Other than islands and beaches, Greece doesn’t seem to have much in the way of competitive advantage.

  4. the ‘leaving the Euro’ option is not realistic: apart from the problem that it is very hard to re-institute the drachme, why would any Greek government want something like that?
    The three issues (default, inclusion in the Euro, and bank solvency) are at the end of the day all politically separable. The most likely scenario:
    1. The Greek government defaults with tacit agreement of the ECB and the EU. It wont be called a default, but something akin to ‘debt restructuring’.
    2. Greek banks come under control of the ECB, which replaces the virtually worthless Greek bonds with something more valuable, as part of the tacit deal.
    3. The Greek government can no longer borrow any money and, because it spends more than it taxes, hence also has to default on its own many internal obligations (salaries, pensions, welfare, building contracts) via a universal cut in payments and services.
    4. After a few years or so the Greek government starts borrowing again, perchance initially from its own banks.

  5. Agree with Paul – i.e. we need a new Brady Plan for Europe, and that would not necessarily involve Greece leaving the Euro. Though I think Greece shows that the textbook problem with currency unions – what do Greek fisherman do when there is a recession in Greece – is not solved by ensuring labour and capital mobility. However, my view is that the Euro is a success. It is a number of European states that are failures.

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