Odds and consequences of a GREXIT

by Jérémie Cohen-Setton and Shahin Vallée on 24th February 2012

What’s at stake: As the private sector involvement is still underway and the application of the conditionality for the second program appear both economically and politically daunting, a growing number of observers have expressed the need to work on an orderly Greek exit from the euro area. The integrity of the euro used to be non negotiable but there is now a growing number of European policymakers that are openly raising the question. Although, some argue that this could help Greece to rebalance its economy faster, there is limited experience of exit in such a financially integrated monetary union and the consequences inside and outside of Greece are difficult to fathom.

The odds of a Greek exit

Wilem Buiter and Ebrahim Rahbari argue that positions of the main EA policymakers seem to have evolved and now suggest a greater willingness by EA creditors and the ECB to support vulnerable, but compliant EA member states under attack (ie. Portugal). EA leaders have come to the understanding that the financial, economic and political cost to the whole EA (and indeed to the EU and the global economy) of material EA break-up (that is exit of other nations than Greece) is substantially larger than the cost of extending conditional support. But EA creditor countries have simultaneously also made increasingly clear that they no longer believe that the costs to the creditor countries of EA exit by one country would exceed the costs of creating a one-side fiscal union, a transfer-union without a commensurate quid pro. As a result, Buiter and Rahbari have increased their probability of a Greek exit to 50% from 30% a few months ago.

Regarding contagion, the authors argue that the degree of exit fear contagion depends on the strength of the different channels of contagion triggered by a Greek exit: direct trade and financial linkages as well as indirect, non-fundamental and sentiment-driven channels. The authors note, in particular, that the gross exposure of EA banks to all sectors in Greece has fallen to at most EUR83bn or 0.5% of GDP and the direct effects should be moderate. Foreign banks have likely continued to shed Greek assets since Q3 2011. Second, the BIS data likely do not capture any of the impairments taken on Greek sovereign holdings by European banks after Q3 2011.26 Third, the reference point to calculate the incremental damage that Grexit could impose on European banks would have to incorporate additional impairments that are likely as a result of a successful PSI – and indeed for future impairments that would occur even if Greece remained in the EA.

Economic sustainability

After the now infamous troika’s debt sustainability report got leaked, Felix Salmon produced a revealing graph about the underlying growth assumption of the plan. Greece is five years into a gruesome recession with the worst effects of austerity yet to hit. But somehow the Eurozone expects that Greece will bounce back to zero real GDP growth in 2013, and positive real GDP growth from 2014 onwards. The downside scenario also looks astonishingly optimistic, as the growth path assumed is barely different from that of the baseline scenario. And under this pretty upbeat downside scenario, Greece gets nowhere near the required 120% debt-to-GDP level by 2020: instead, it gets to 159%.

Jacob Fund Kirkegaard writes that the growth assumptions might not be that unrealistic after all. According to the IMF estimates, Greece will suffer a cumulative decline in real GDP of about 16 percent from 2009–12, taking the country to near Latvian recession levels. By any definition, that is a “deep recession.” According to the Zarnowitz Rule – that “deep recessions are typically followed by steep recoveries” –the projected Greek GDP growth rates after 2013 are extremely conservative, assuming that Greece implements its new IMF reform program. The prospect of Greece not experiencing any noticeable cyclical rebound looks highly implausible in his opinion. The question can be asked: why has the IMF assumed such low future growth rates in its relatively benign baseline scenario? The IMF may just be extremely wary about Greek growth prospects, which would be understandable. But its caution on growth rates from 2013 to 2020 could also be part of an attempt by the Troika (the European Central Bank (ECB), the European Commission, and the IMF) to “sweeten the PSI deal” by ensuring that any GDP-linked securities will pay out a bit more generously if Greece avoids another default. This prospect could therefore entice more private creditors to sign up for the swap.

In an interesting post about the respective role of blogs and news organization, Felix Salmon points that it took more than 6 hours for the primary document of the now infamous  leaked report on debt sustainability to be available online after Reuters and the FT run the first stories on it. One lesson is that legacy news organizations like Reuters and the FT still don’t think digitally: the unit of news is always the story, rather than, say, a primary document in PDF although the analysis itself was intrinsically superior to any of the news reports written about it. Sometimes, reporters can add value when they write up primary documents, by putting them in perspective and in plain English. Other times, they miss important things. Either way, posting the document itself along with the write-up can only make the news story richer and more valuable.

It’s the politics stupid…

Gideon Rachman emphasizes that – beyond the question of whether the latest deal provides is economically sustainable – there is also the question of whether the deal is politically sustainable. The question of political sustainability arises most obviously in Greece where parties of the far-left and the far right currently command around 50% in the opinion polls. But the problems of euroland are also disrupting politics in creditor countries, where the economy is in better shape. The Netherlands is a fine example. There, the party that currently tops the polls is the hard left, Dutch Socialist Party – which, unlike Labour, is strongly opposed to the Greek bailout. The far right Freedom Party of Geert Wilders is also still polling strongly – and is faring much better than the traditional centre-right party, the Christian Democrats.

Barry Eichengreen, Kevin O’Rourke and Alan de Bromhead have a new paper on the political consequences of recessions. Based on a cross-country analysis of the Great Depression, the authors confirm the existence of a link between political extremism and economic hard times. What mattered was not simply growth at the time of the election but also cumulative growth performance as the support for right-wing anti-system parties was the greatest where depressed economic conditions were allowed to persist.

Which Latin lessons

Guillermo Ortiz and Mario Blejer argue that taking Argentina as an example of what Greece should follow is a bad example. Unlike Argentina, Greece belongs to a formal multilateral arrangement that could provide the intensive care and official finance needed to smooth the adjustment. In the case of exit, the situation of the private sector in Greece would be worse than Argentina. Indeed, many Argentinian contracts continued to be denominated in pesos, since the currency board did not eliminate the local currency. These contracts, at least, could be honored. But Greece would have to deal with the complete universe of covenants since every contract would need redenomination. A sea of bankruptcies would follow. The authors conclude by saying that what is required is a framework adapted to the specific context of the euro zone and of Greece itself. Such a framework should recognise that the process of adjustment and reform will extend over a long time horizon. The IMF is analytically ill equipped for long-term engagements, but this type of programme is best designed and implemented within the euro framework. Greece is in for a long and difficult journey, but the voyage will be less traumatic and more successful if it is undertaken within the euro zone, not outside it.

Daniel Marx – former Chief Debt Negotiator for the Republic of Argentina – argues that Mario Blejer and Guillermo Ortiz have not sufficiently emphasized certain elements of the Greek situation, which, when taken into consideration, could well alter their conclusions. In particular, Marx notes that although the Argentine restrictions on bank withdrawals (corralito) and the mandatory conversion of bank foreign currency assets and liabilities (pesoification) did not deserve to be in the template of policies as these measures had very poor cost-benefit outcomes when factoring in their effects on economic activity (outflow of resources, overshooting of the foreign currency and inflationary consequences), the trade-off for Greece might be different. These measures unduly penalized domestic savers and did not even benefit larger debtors as the bulk of whose debts were governed by foreign law. In this respect, Greece has a comparative degree of freedom since domestic law governs most contracts.

How would Greece leave?

Naked Capitalism outlines a detailed plan for euro exit which work as follows:

1.       The redenomination of the Greek public debt, which they can largely considering most of it is under Greek Law.

2.       The euro would remain a legal tender but the new drachma would be pegged at 340.75, exactly the same rate as the Drachma was fixed on 19 June. All debt under Greek law would be redenominated into New Drachma at the 340.75peg. This would effectively bring us back to 31 December 2001 for Greece.

3.       Taxes. The government would announce that henceforth it will tax exclusively in New Drachma. All municipal governments would be required by law to tax in New Drachma. 

4.       Banks. Like the Argentines before them, the Greek government would convert all euro bank accounts legally into New Drachma. The systems would process as if it were euros because of the fixed peg, but legally the money would be New Drachma. This would make the Greek economy “euroized” but make the banking system redenominated into New Drachma.

5.       Retail. Retailers, all sellers of Greek goods, would then be forced to return to the double accounting treatment of pre-2002 whereby they denominate all transactions in both Drachma and Euros. Again, the paper money would be euros and each euro would initially be worth 340.75 New Drachma. The electronic money would legally be New Drachma, even while the systems said euro.

6.       Float. On day one, immediately after redenominating, the Greek government would drop the 340.75 New Drachma exchange rate peg and float the new Drachma as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between euro and New Drachma.

7.       Physical currency. New Drachma would be printed by the Bank of Greece and introduced to replace euros.

Bill Mitchell argues that the implication that capital controls are chaotic would not sit with Malaysia during the Asian crisis. Malaysia gained major benefits from adopting this strategy in 1997. The IMF has demonstrated the conditions under which capital controls, previously eschewed by free market ideologues, can be highly beneficial to a nation making large currency adjustments.

Policy dilemmas and the value of waiting

Daniel Davies from Crooked timber writes a very good post in the form of a role-play that shows the intricacies of the ongoing negotiations and intends to give the reader an authentic international financial diplomacy experience. In this game, the reader can choose his own Troika Program for Greece as a junior member of the One World Government, and travel with the help of its advisor (Maynard) through the steps of tricky negotiations.

Paul Krugman using Daniel Davies’ role-play points to the dilemmas that policymakers from the periphery face. Unilateral default won’t solve the competitiveness problem, and at least for now would actually worsen the fiscal squeeze, since they’re all still running primary deficits. (That may change in a year or so). Euro exit would allow a quick devaluation, solving the competitiveness problem — but it would be hugely disruptive and would generate vast ill-will, so it’s hard to see any government taking that step until there really are no alternatives (which may soon be true for Greece, but not the others). For the most part, there is no magic bullet for these policymakers. The only thing they can do is wait for things either to get gradually better via “internal devaluation” or to get worse and provide the economic and political environment in which euro exit becomes a real possibility.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

Republishing and referencing

comments powered by Disqus

Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote online comments or analyses without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.