The Return of the Greek Dra(ch)ma

Economic analysis by Filipe R. Costa

Much has been said and written about Greece for the last few years, as the country faces one of the most severe crises ever seen and has been a thorn in European politicians’ sides. While the “other students” have done it right, Greece continues to misbehave, eager to put a stop to spending cuts and privatisation. Since the Syriza party ascended to power, much has been played between Greece and the EU, in what has been a high stakes game at the political level, in which each party seems to be happy to go “all-in”. But, according to last week’s draft deal between the parties, Greece will be granted a 4-month extension on the current bailout plan, as the initial Syriza hardness is softening a little. Or, quite possibly, the Greek Finance Minister Yanis Varoufakis is just willing to keep all options open while gaining some time until he finds a solution with broad support from the population.

For now Greece will most likely stay in the euro, an outcome that will kick the can farther down the road instead of dealing with the bankrupt state in which the Greek economy exists. After experiencing a decline of 25% in its GDP and facing rigid rules imposed on any money borrowed from its creditors, the benefits of leaving the euro are rising, even if that would result in short-term inflation and political turmoil. Debts are not sacrosanct as Angela Merkel thinks. If they were, the interest rate on debt would be set equal to the risk-free rate, but I guess that has never been the case. So, a default is not dramatic; what is dramatic is buying debt as if there were no risks attached.

Mission Impossible

When country A decides to peg its currency to that of country B, it must be willing to follow the monetary policy pursued by B. Unless both economies are relatively synchronised in terms of the business cycle, some painful adjustments may occur from time to time (citizens of the UK know this from their experiences in the ERM in the early ‘90s). The Swiss, for example, used to peg their currency to the euro, but predicting a massive inflow of money to the country they decided to cut the cord. In the past Thailand used to peg the baht to the US dollar, but as inflation was so vastly different in both countries, the peg was unrealistic and they were also forced to abandon it. In the Eurozone’s case there is also an arrangement that is similar to a peg but with the detail of it being (supposedly) irrevocable. Greece irrevocably “pegged” the drachma to the euro at the rate of 340.75:1, which is an unrealistic level given that the Eurozone and Greek economies have been diverging. Inflation has been rising much faster in Greece for years and the country has lost competitiveness, which will be very difficult to regain without tweaking the current peg. But that would mean abandoning the euro.

If Greece was not part of the Eurozone, it could allow its currency to float, which most likely would lead to a massive devaluation. Such devaluation would make domestic products more competitive as they would be worth much less in terms of foreign currency. At the same time, imports would be much more expensive and unattractive. The currency free float would allow the drachma to adjust to a bearable level and the current account and competitiveness would improve.

I have heard all kinds of nasty disadvantages pinned to a Grexit, as if Greece were much better inside the Eurozone. Most of the disadvantages have been amplified by politicians to create fear, but many economists are of the opinion that a return to the drachma could be the best option for the Greeks, in particular if creditors continue to impose tough conditions on their loans making it impossible for the country to achieve any growth in the years to come. After experiencing a crisis that has reduced living standards by a quarter since the end of 2008, Greece should now be recovering at a 5% or 6% pace. But that is far from the current reality.

Greece was able to improve its current account balance to a level near 0% of GDP, after hitting a record high of 15% in 2008, but most of the gain has been the result of recession rather than increased competitiveness. Imports declined substantially because the Greeks no longer have the money to afford them, while exports didn’t improve much. Without currency depreciation, the country will go down the painful direction of dealing with internal devaluations. As prices have been rising faster than in the Eurozone for years, I guess Greece needs to enter a severe period of deflation to catch up, something that would be similar to what happened in the US during the Great Depression. I don’t believe any government would sanction that after six years of austere conditions. By the same token, even if that route were feasible, Greece would still be exposed to a euro float that could undermine the country’s prospects if it rises while the economy is in contraction.

The Bailout Story

European politicians have been praising the efforts of Portugal, Ireland, and other bailed out countries for what they have achieved so far. Politicians in peripheral Europe always mention the low yields on their sovereign debt as the proof for their success while they never mention GDP growth or unemployment levels. No matter how you put it, the real truth is that no significant achievements were made in these countries as they still lack growth and have colossal unemployment rates while debt is still more or less at the same percentage relative to GDP as before the bailouts. The reason for the “yield” success is solely the ECB intervention, as Draghi has been promising to do whatever it takes and to buy sovereign debt when needed, as long as these countries are on a reform programme. That is the main reason why a 10-year Portuguese sovereign bond can be bought at lower yields than a 10-year US Treasury.

The Alternative Grexit

So, a lot of drama exists in turn of the potential Grexit but most of it was aimed at creating fear. There’s no good economic reason to believe that defaulting and leaving the euro is bad for Greece. Two recent episodes confirm it may indeed be the best option, and that it should have occurred long ago.

Not that I believe we should not assume our responsibilities in full. But there are limits to everything. Bondholders are paid for the risk of default, taxpayers are not. A bondholder or creditor is someone that lends money to a company, institution, country or any other type of entity for an interest payment. The interest received should pay for credit risk because sometimes it happens that the loan taker defaults on the payment. If someone is prepared for the risk, it should be the creditor.

With that in mind, Iceland opted to allow its banking sector to default on loans. Even though the British and Dutch governments didn’t like the idea, as $6 billion was lost by their citizens, the Icelandic government preferred to put the banks into receivership rather than bail them out for $85 billion at the cost of the taxpayer. After all, what attracted external funds into the Icelandic banking system (worth 6 times GDP at one point), was the higher interest rate offered. Why would the government bail out investors who are compensated by the risk they bear? If a bailout were to happen every time a default occurred, interest rates should all be set to zero (or merely to compensate for the inflation rate).

Let’s consider the case of Argentina. The country went through a major recession between 1998 and 2002 that culminated in a default on $93 billion of sovereign bonds. Instead of going down the bailout route, the solution was again to recognise the impairment. This resulted in a sudden and abrupt rise in inflation while erasing 10.9% from GDP in 2002 but the recovery started the following year.

The cases of Argentina and Iceland show that under certain conditions a severe economic crisis may very quickly lead to trouble in government finances. A rising unemployment rate and a sudden decline in GDP is unavoidable no matter how the government chooses to deal with it, but it is undeniable that sometimes the better option is to write down the proverbial elephant in the room. After defaulting, Argentina and Iceland suffered huge inflation, sudden declines in GDP and huge rises in unemployment, but started recovering right in the following year. In contrast, Greece has effectively existed in an economic void for six years now. Growth in Argentina averaged more than 8% for the five years following the default while the unemployment rate declined from 22.5% to 8.5%. Iceland experienced two years of negative growth but has been growing much faster than Europe for the last four years. Its unemployment rate hit 8.1% at the height of the crisis but is now at 4.0%.

Greece has experienced six years of falling GDP in what amounts to a cumulative 25% fall in living standards while unemployment has been rising every year. The solution to this problem seems pretty obvious to me. It’s up to Greece to decide between the drama and the drachma…