Observations on a possible Grexit


[this was first posted on Clubtroppo 9 days ago. Since everything went to script after that, the text below is unchanged]

After two weeks of a new government in Greece, a Greek exit from the Euro (termed a ‘Grexit’) looks more and more likely. The betting markets give it about 30% to happen this year, and Greece is the out and out market favourite to exit the Euro before any other country.

Though I have not followed it super-closely the last 2 years, I have some observations to offer:

  1. Greek politicians are very used to being in the situation of owing other countries money and negotiating more favourable terms. In a way, their hand is the easy one to play as they can credibly claim not to be able to pay back the debts and then offer to promise to pay back something, with the alternative being open bankruptcy for which they would then blame the lenders. If the lender is owed enough money, the lender often reluctantly plays along in the hope of getting something back. This strategy has worked well for the previous Greek governments, which have quite successfully in the last 7 years gotten 3 bailouts, and the current government should be favourite again in the current situation to come out with an even better deal than before.
  2. The political imperative to pretend that Greece will pay back its loans is diminishing on both sides of the loan relation because of increased concentration of debts. The Greek state now directly owes the rest of the EU in that 80% of its debt is mainly to tax-payer owned entities outside of Greece (EU governments, the ECB, the IMF, etc.). This puts Greece into a great position to get a better deal as the Greek state has taken over many of the debts owed by Greek banks (meaning bank collapses are less of a worry), and European tax-payer institutions can rationally hope to simply have the ECB print the equivalent amount of money that they would have to write off as lost Greek debts. This printing-to-cover-debts is already starting to happen as the ECB has announced it wants to buy up government bonds, effectively a form of money printing for governments. For Greece, this means that an official bankruptcy would save the Greek state close to 150% of GDP in terms of liabilities, without the Greek banks being as exposed as in 2007 (Greek banks owe the ECB around 75 billion euro in fairly low-interest loans).
  3. Previous Greek governments have successfully sabotaged many reforms they agreed to. The most glaring example is tax evasion, where Greece was ‘forced’ to increase the number of tax audits, the severity of the punishments, and the transparency of tax duties and tax arrears (read here). Yet, tax arrears still increased from 45 billion in 2011 to 70 billion at the end of October 2014, as the previous government made it simpler to have taxes declared uncollectable. There is also no indication whatsoever that the 2000 high-profile Greeks who were named and shamed in the famous ‘Lagarde’ list of tax frauds have lost their influence in Greece or in any other way been held to account – though the Greek journalist who leaked the list that the Finance minister had kept secret for years had to fight off 2 court cases. Similarly, the story of the supposed privatizations of state assets in Greece is one whereby Greek politicians were keen to ensure a lack of transparency and impartiality in the sale of their assets and frustrated any real privitizations (you can guess why!). Somewhat humorously, Germany has again offered the new government to send 500 tax collectors to Greece.
  4. The plan floated for some years now by the Greek finance minister Yanis Varoufakis and his friends in Europe (such as Jaques Delors) to have a large EU-wide spending spree via an accelerated spending of the ‘structural funds’ strikes me as deeply naïve. For one, the budget of the structural funds, some 40 billion Euro per year, makes up no more than 0.3% of EU GDP, making it small biscuits in the scheme of things. More importantly, the whole idea that there are lots of big projects to be identified by central bureaucracies that will engage the masses of unemployed in meaningful activities, smacks of a bygone belief in central socialist planning. The European Investment Bank and the structural funds are already struggling to find meaningful projects to finance, often accused of funding expensive goat tracks, so one should not expect the same European bureaucracy to suddenly find a large flood of meaningful things to do for the Greek unemployed. I personally think the way to go would be to have all citizens of Europe have a direct account with the ECB which can the create liquidity via those accounts, bypassing banks, a proposal you now see more often in European economic debates.
  5. The new Greek government is floating silly stuff, like a claim for German war reparations, unnecessarily berating the Troika, threatening to become friends with Russia, and grandstanding about democratic values. Whilst this might appear cool for the home front, it is essentially empty bluster that will alienate the decision makers in the capitals of Northern Europe and Washington. It will make it harder for the ECB and European leaders to be seen to agree with further Greek bailouts and thus increases the probability of a Grexit – European leaders have shown in the last 7 years they don’t mind subsidising a hopeless cause but to do so whilst being publicly berated would make that choice dangerously visible.
  6. If one considers what the fundamental difficulty with a single currency is in Europe, then the only ‘deep’ reason I have been able to come up with in the last few years is a difference in the ability of some political systems to curtail the wage increases of public sector employees and welfare recipients: one needs an asymmetry in market distortions across Europe to explain why market price adjustments haven’t yet ‘cured’ the problems of a single currency, and asymmetry in the price policy of governments is the key candidate. The story is that in Southern Europe, including France and Italy, the introduction of the Euro was followed by large real increases in the wages and welfare payments of those connected to the state, whilst in Northern Europe these increases were more modest since they followed a longer tradition of low inflation and negotiated central bargaining. Before the Euro, these increases in prices set by central governments in Southern Europe were simply off-set by bursts of inflation, maintaining a healthy ratio between public sector payments and private-sector wages, and hence not destructive. Being in the Eurozone took away that natural market reaction though, which then lead to increases in debts, property bubbles fed by these debts, distortions in the allocation of talent in the economy (the talented were queuing up for the over-priced and safe government jobs) and eventual collapse. The only real way to redress the price imbalances within the Euro system were then to openly reduce public sector wages, fire public sector workers, and reduce state payments across the board, which reluctantly happened to some degree, but of course lead to levels of unemployment and unpopularity that inflation (which has the same effect) would not have led to. Outside of the Eurozone, inflation could have returned relative prices to sanity much quicker and to levels not pre-determined by governments, which is why in hindsight I think it would have been much better for Greece, and perhaps also the other Southern European countries, to go bankrupt in 2008 and re-introduce their currencies. Btw, I never for a moment bought the line that Southern European governments could escape this ‘austerity’ via some nirvanic Keynesian spending spree that would lift all boats and prevented this tough relative price decline.
  7. How bad would a Grexit be for Greece? In the early days of 2008/2009, it would have been pretty bad, with massive capital flight and a string of banking collapses. Currently, I think it would only have a short-run negative effect on Greece, followed by a strong upsurge, much like what happened in Iceland after its bankruptcy (tellingly, Iceland unemployment rates currently stand at below 5%, compared to over 20% in Greece). You see, Greece already has a primary government surplus and much of the savings and the capital already left in 2010 and 2011, with capital flight reappearing in the last 6-months in anticipation of a possible Grexit. The internal relative prices in Greece are still out of whack though (see here for comparisons of public sector pay across the OECD, which identifies Greece as having levels of pay for teachers close to that of Sweden, on a GDP per capita close to the Check republic with roughly 30% lower wages), for which a bout of inflation would be the obvious solution that its membership of the Euro is preventing from happening.
  8. The main internal problem in Greece is that it has been run by the wrong crowd for a long time now – the very people who were avoiding taxes and abusing their political power were being asked by European governments and institutions to solve the problems they had created, and you can guess how they worked that to their advantage! The main thing you can accuse the Germans of is naiveté with regards to the Greek elite leading to their de facto support of the wrong crowd. The new government has promised to take this old elite on, which will be a mammoth task as they will occupy local councils and be dominant inside most of the public institutions. Inside the Euro or outside, that will be the main battle and the rest of Europe will, I think, have little effect on the outcome: imperative in the political struggle to increase accountability and the rule of law throughout the upper echelons of politics, business, and ministries, will be the emergence and maintenance of a group of new political leaders who start out with the right intentions and who face the right incentives. That requires mobilisation of a whole generation of new leaders who see little alternative. European money in many ways creates the wrong incentives in that it increases the value of simply being in power and hence being the first in line to receive foreign aid. Without European subsidies, increasing the size of the local pie will become more important to Greek politicians, and it takes away the ability to blame outsiders for failure.

In short, hurray for a Grexit! May it happen sooner rather than later, though if I had to bet I would gamble on further muddling through via additional Greek bailouts. The real game is inside Greece though and I wish the new government all the best with their endeavours to dislodge the old elite and put a more accountable one in its place. I do hope Yanis and his friends stop grandstanding though about stuff like German war reparations and being holier-than-thou when it comes to democracy, for it makes them look decidedly shabby.

4 Responses to "Observations on a possible Grexit"
  1. Paul,

    You have a lot of good observations. I’m not well versed in monetary economics so please bear with me. I recently started reading market monetarist blogs, so most of my arguments are attempts to restate their views. I think that a helicopter drop would certainly be better than current policy, but less effective than a nominal GDP level target. If the ECB is targeting inflation, then increased private spending will be offset by tighter monetary policy right?

    I’m not quite sure I follow your point 6. Are you saying that nominal wage rigidity is greater in the public sector in Southern Europe? If so, I definitely agree. Why shouldn’t the ECB lift inflation across the Eurozone so that wages will adjust faster? It’s not like wages are sticky in the upward direction, so the Northern Europeans won’t be worse off because of the higher inflation.

    I agree that a Grexit is likely the only way for Greece to eventually start reform. I wonder what it is that makes some nations better at reform than others. Australia seems to be quite good at structural reform, even though I don’t see the average Australian as being more politically informed than the average Frenchman. It seems that the political parties here have a high level of internal competition and Aussies have less personal allegiance to any political ideology (a surprisingly successful mix?)


    • Hi Ravi,

      nope, its a common misconception by many monetarists that printing money and running fiscal deficits are the same thing. That opinion essentially comes from views wherein money does not truly exist, ie is merely a unit of account and only real values matter. Then, money printing leads to transfers. Despite 2 great recessions, theories in which money really matters for the economy and you get thins like liquidity traps, debt cycles, nominal rigidities, etc., are still rare in monetary circles. Odd, really.

      Think also of how a helicopter drop can be done. You need an administrative apparatus to give every citizen a bag of money. That means defining a target population, having them register, updating the register with newborns and deaths and migrants, etc. The central banks are not even beginning with the task of setting up that infrastructure.

      No, its not merely nominal wage rigidity, its also a kind of inbuild penchant to over-promise, ie “nominal growth rigidity”. All kinds of reasons for that, some institutional, some cultural.

      Australian reform is indeed an odd example.

      • Thanks for the thorough response Paul! My impression was that the monetarists almost all recessions on changes in monetary policy. Recent events seem in line with your predictions. Greece is still getting money and Europe is only getting promises for reform in return. Expectations seem to matter a great deal for both monetary policy and political bargains. I still wonder what causes some countries to be so much better at reform than others.


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