Despite the rhetoric emerging from recent European summits, it’s increasingly likely that sooner or later Greece will have to default “properly” on its huge debt and leave the euro.
The country is mired in a vicious downward spiral of recession, spending cuts, an overhang of debt, lost competitiveness and effective insolvency.
The only way out ultimately is to recognise the severity of the crisis affecting the country and plan an arranged default on its debt and exit from the euro (a ‘Grexit’) supported by international organisations that as far as possible minimises the damage to the Greek economy and its people, as well as those countries remaining in the eurozone.
While some say Greece has already defaulted under its recent financing package, debts were not reduced anywhere near enough to give Greece the economic ‘headroom’ to start growing. Even after years of austerity the debt-to-GDP ratio will still be punishingly high. And even if Greece was able to pare down the debt without killing its economy through an acute aggregate demand shock, the country anyway has a huge competitiveness problem.
That competitiveness problem can’t realistically be solved through an ‘internal devaluation’ as is now being attempted, with real wages being cut, as this simply exacerbates the already crippling Greek recession and stretches it well into the future.
The only alternative is an “external devaluation”, in other words to depreciate its currency. That, of course, can’t be done unilaterally as Greece is part of the eurozone. But with little current prospect of Germany allowing higher inflation in the eurozone and a depreciation of the euro with the rest of the world, that leaves the very real prospect of Greece leaving the euro.
Put simply, without currency depreciation and growth, Greece’s debt to GDP ratio won’t come down. That means leaving the eurozone at some point so as to depreciate the “new Drachma”, boost competitiveness and offer the chance of some growth.
Those warning against such a course of action stress two risks. It’s worth highlighting them in order to reinforce the point that a “Grexit” alone won’t fix the problem, but needs to be seen as part of a package of wider measures to save the euro and restore growth in Europe.
The first risk is the shock to the financial system that would ensue. The foreign euro liabilities of Greece’s banks, businesses and government would jump in value and need to be converted to drachmas. Banks exposed to Greek debt would face real problems, as would banks in turn exposed to them. And therein lies the real problem – the vulnerability of the European banking system to another shock, and the risk of another credit crunch.
In fact, so far the European Central Bank (ECB) has had to pump in around a trillion euros to European banks to stop a full blown credit crunch emerging. Instead of lending that money to other banks on wholesale markets, banks have largely simply put it back on deposit at the ECB, given their lack of confidence in other banks. Banks across Europe would probably need to be recapitalised and restructured, with utility banks carved out of existing ‘zombie’ banks and supported.
The second risk highlighted by those opposed to Grexit is the contagion that could ensue as other economies are dragged into the crisis. But that misses the point. Other countries like Portugal and Spain are already in crisis. Portugal may anyway have to restructure its debt and leave the euro like Greece. A faultline in effect exists between the eurozone core (economies similar to Germany for which one currency and one monetary policy makes economic sense) and peripheral countries which function differently.