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.