Monday, 23 March 2015

Impacts of Grexit

Many analysts and commentators have been discussing the potential of a Greek exit from the Eurozone, or “Grexit”. This is a very complex subject which cannot easily be assessed without a detailed econometric assessment of Greece’s economy and a wider assessment of Greece’s polity and society. What is possible is to explore some major themes and issues of a Grexit, and examine some relative impacts these may have on Greece’s economy and society. As there are a large number of variables involved, what follows is more of a concept note than a specific forecast.

This article was originally written on 12 February 2015 and first appeared on the Navigator website

Issue 1: Grexit within the Euro

Contrary to popular understanding, a “Grexit” does not necessarily mean a new currency will be introduced. The key monetary requirements for participation in the Euro are in fact contained in the Maastricht criteria of the Maastricht Treaty. It should be clear from an examination of these criteria that Greece has been in violation of the Treaty since it joined the Euro, yet it has continued to use the Euro currency.

One definite alternative is that Greece will unilaterally default but remain within the Eurozone. What does this mean?

·       Greek banks and the Greek government would be barred from using European Central Bank refinancing in all but the narrowest of transactions (this is now already the case).

·       Other Eurozone countries no longer accept Target 2 transfers, or specifically, liabilities, involving Greek transactions. There is no precedent for this, and it is uncertain how this would work in practice.

·       Any other Eurozone public sector financing of Greece stops. This might include a cancellation of disbursements of European structural and cohesion funds. 

·       Greece’s credit rating would of course fall to unprecedented lows, and any form of foreign investment or lending would be eliminated.

In this case, the practical impact for Greece businesses and citizens will be that:

·       The Greek banking system will effectively have to be either nationalised, liquidated and merged, depending on the severity of the problem. The Greek state currently controls the majority of shares in three of the four systemic banks and would be within its rights to take drastic action.

·       The Greek banking system will quickly implement capital controls, preventing deposit flight and outbound transfers.

·       The Greek government will begin honouring its commitments (salaries, pensions, etc) using a mix of cash and promissory notes or Greek government bonds.

·       A barter economy will quickly grow, replacing cash transactions.

·       A black market for cash leaving or entering the country will quickly emerge.

·       Official economic activity will fall dramatically.

Many economists will no doubt respond that this idea is preposterous: that the idea of Grexit is to leave the Eurozone, develop a new central bank and currency, and allow that currency to devalue as a means of regaining competitiveness and control of the economy.

But this is not so simple, and any move in this direction will almost certainly include some of the preliminary stages discussed previously. Why?

·       Because the majority of the Greek population does not want to leave the Euro. Doing so carries an important political risk for the ruling party that proposes such a move.

·       Because even if Greece has a new currency, as long as it is in the European Union it is bound by the “Four Freedoms”, or free movement of people, goods, capital, and services. As long as this is the case, Greece cannot unilaterally levy the tariff and credit barriers which are a necessary complement for a currency devaluation to function. It will still be part of a common trade area in the EU (and by extension China and other non-EU countries), and will still have grievous competitive disadvantages in the real economy.

·       Because even a Grexit does not mean that the national debt is eliminated (see next section, below).

Issue 2: Grexit outside the Euro

Grexit, as usually implied in the press, necessitates Greece developing a new currency (the “NewDrachma”), managed by the Greek Central Bank. Many analysts, including Paul Krugman, imply that Grexit is manageable, and that the current costs of the Greek bail-out are equivalent to the economic damage expected from Grexit anyway.

But this scenario is also flawed. It ignores—or assumes—that simply by exiting the Euro, Greece’s public debt will disappear. It will not.

Nearly 80% of Greece’s € 322 billion public debt is in the hands of official creditors. There is no reason to assume that:

a.     This debt will be forgiven following Grexit, and/or
b.     This debt will automatically be re-denominated in New Drachmae.

It is sloppy intellectual reasoning to imply that either of these two conditions will materialise as a fait accompli of a Grexit.  

The damage of Grexit under the current circumstances is the worse of all worlds. It would require a rapid deflation of the New Drachma against other hard currencies, while making the public debt impossible to service. In fact, this scenario is exactly what happened to Germany in 1919 at the end of World War II, when it was forced to pay reparations in gold or foreign currencies.

The result of Germany’s experience is in the historical record: hyperinflation, poverty, and the rise of extremism which lead to Adolph Hitler’s takeover of the Reichstag through a mix of legal and extra-legal means.

As a result, a classical economics analysis of Grexit would assume the following:

a.     Immediate devaluation of the New Drachma by 40-60% against the Euro and US Dollar. Greek GDP would automatically fall by the same percentage in hard currency terms, creating a renewed cycle of uncertainty.

b.     All important trade and other contracts would remain formally or informally pegged to the Euro or US Dollar Libor or Eurobor rate, creating an incredible pressure on the New Drachma. This has been seen in Russia following the 1998 devaluation, and even in Greece prior to Euro entry.

c.     Imported products, including most consumer goods, automobiles, oil and gas, and many foodstuffs and stables, would automatically become 40-60% more expensive.

d.     Inflation will begin rising to 15-18% per year in the best case scenario in the 2-3 years following the new currency.

e.     Greek exports and service exports (tourism) would become more competitive. However, they would be deprived of working capital necessary to finance imports, exports, or the 3-6 month credit term demanded by most tour operators for Greek hotel rooms. As a result, Greek enterprises will not be able to take advantage of the declining currency, at least not in the short term.

f.      Greek services and products sold in the domestic market would become more competitive, assuming that the large majority of their inputs are sourced in Greece. For instance, Greek potato chips made from Greek potatoes would be more price competitive that Greek potato chips made from Polish potatoes (depending on the cost of energy, transport and packaging).

g.     Inflation and uncertainty will lead to an immediate fall in consumer spending and investment, at least over the short term.

h.     Greek banks would likely be forced to convert their Euro-denominated loans to New-Drachma-denominated loans, at the starting price of the New Drachma. As the New Drachma devalues, however, the headline cost of the loan would increase either in or out of proportion with the devaluation and/or inflation. So either the banks will go bankrupt through loan write-downs (and borrowers will benefit), or borrowers will be strangled by an ever-appreciating cost of their loan. Whatever the case, new credit issues from Greek financial institutions will be eliminated.

i.       Strict credit and transfer limits will be introduced. Cash withdrawals from banks will be limited. International outbound transfers will be limited. Incoming transfers or cash exchanges will be automatically converted at the low, “official” rate. There will be a growing gap between the official and unofficial exchange rates for the New Drachma.

j.       A lucky few and the politically-favoured will enjoy access to scarce credit. Everyone else, including healthy enterprises and families, will suffer. We have seen this scenario before in Greece, notably with who got loans from “private” banks or state-backed banks such as ETBA.

k.     It must be emphasised that even with a devalued New Drachma, Greece remains part of the Eurozone. As a result, we can expect fire sale prices of vacation homes, agricultural land, companies and all kinds of other assets, as European investors descend on Greece eager to take advantage of their strong currency, and as Greek owners desperately sell at any price. Much of the transactions will be done offshore or “under the table”, enabling the Greek seller to avoid tax and keep hard currency income.

l.       Black market activities will increase. Labour migration outside of Greece will increase. Barter activity will increase. Formal economic activity will fall still further.

It is difficult to forecast how long the adjustment shock would last, but I believe that 2-4 years will be necessary before the economy begins to grow and function again at anything approaching a normal trend rate.

In time, assuming stable political developments, one could imagine Greece returning to the economic system it enjoyed in the late 1980s: a continually-devaluing national currency; high inflation; very limited credit; rampant demagoguery and corruption in the political class. The last point has arguable not changed much since then.  

But now we need to ask what happens not from a classical economics viewpoint, but from the social and political viewpoint. This is perhaps best done by posing a series of questions that are rarely heard.

a.     Why should we assume that Greece will remain stable?

b.     How long will Greece remain a democracy given the relatively calm scenario discussed above? How long will it remain a democracy given the presence of political parties which have relied upon extra-legal tactics in the past?

c.     Who will be the next “man on a horse” (one of many in Greek history) to “save Greece?”

d.     Can Greece survive in the European Union even if it exits the Eurozone? Can it survive a devalued currency given its free market agreement and inability to set protective tariffs? 

e.     Will other European partners tolerate continued Greek involvement in European decision-making and support programmes given the magnitude of the implied default? Or will other European societies turn against Greece, and against the Greek diaspora communities living in their midst?

f.      Can Greece continue to defend its national borders against an irredentist neighbour when it will be unable to buy fuel, spare parts or ordnance for its military, or when its European partners will be manifestly unwilling to get involved in any further Greek adventures?

g.     Viewing the constant scenes of poverty and tension in Greece, what happens to foreign tourism arrivals in the immediate aftermath of a devaluation? Do we really assume that tourism and normal economic flows will remain unaffected? 

h.     What will popular reaction be when the population views “locust investors” asset-stripping Greece at low prices, or hears yet more tales of starving schoolchildren?

As stated previously:

·       There is no point in Grexit without a simultaneous exit from the European Union, allowing Greece to fully set its own tariff and credit policies.

·       An exit from the Euro neither cancels nor re-denominates Greece’s sovereign debts.

·       Given Greece’s failure to manage its economy and public sector properly over 30 years of prosperity, we should be under no illusions that it will do any better in the economic depression and crisis that would follow a Grexit.

(c) Philip Ammerman, 2015 

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