By Nouriel Roubini
· Greece is highly likely to default on its debt and exit the eurozone (EZ) either this year or next. The question is, will this process be orderly or will it be disorderly? A Greek exit from the euro would be painful, but the collateral damage to Greece and to other distressed EZ members can be contained if this exit is orderly and partially financed by Greece’s official creditors (the troika). The alternative to an orderly exit is a spiral into depression, bringing with it social and political chaos and, by next year at the latest, a disorderly default and exit.
· The recent debt-exchange deal was inadequate but, even if Greece had been given real and significant relief on its public debt, it cannot return to growth unless its competitiveness is rapidly restored. However, the only way to do this is via real depreciation, and the only realistic way of achieving that in Greece’s case is via a return to the drachma. Following a sharp depreciation, this would quickly restore competitiveness, improve the trade balance and rejuvenate economic growth.
· This would of course be a traumatic process, but I argue it would be less traumatic than sticking with an unhappy EZ marriage, which is likely to eventually lead to a disorderly divorce. The experiences of Iceland and many emerging markets in the past 20 years show that a nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness and growth.
· The collateral damage to Greece and other distressed EZ members can be contained if the exit is orderly and negotiated and financed by the troika: Official resources will be needed to recapitalize Greek banks and prevent the exchange rate overshooting; the redenomination of euro debts into new drachma claims will have to be negotiated; a partial moratorium on public debt owed to official and private creditors will have to be agreed; and temporary capital controls and bank holidays will also be necessary. Moreover, significant official resources will have to be used to limit the contagion to other EZ periphery members that are now under serious financial strain. The troika may not be happy to finance a Greek exit, but a disorderly exit would cause massive contagion to the rest of the EZ. Thus, an orderly divorce with side payments is a better choice for both sides than a disorderly break-up.
The Greek euro tragedy is reaching its last act: Greece is highly likely to default on its debt and exit the EZ either this year or next. Postponing the exit with a new governmentcommitted to a variant of the same failed policies (front-loaded recessionary austerity and structural reforms) will not restore growth and competitiveness as Greece is now stuck in a vicious cycle of insolvency, low competitiveness, un-financeable large external deficits and ever-deepening depression.
Indeed, fiscal austerity makes the recession worse in the short run, and even the necessary structural reforms would be initially recessionary. For example, making labor markets more flexible allows public and private employers to fire workers more easily, which will act to deepen the recession before it improves growth. To extricate itself from this depressionary and deflationary trap, Greece must now begin an orderly default and exit that is coordinated and financed by the troika to minimize the collateral damage to itself and the rest of the EZ.1
Even an Adequate Debt-Exchange Deal Would Not Have Been Enough
The recent debt-exchange deal provided much less debt relief than Greece needed. If you pick apart the figures, and take into account the large sweeteners the plan gave to creditors, the true level of debt relief was small. Moreover, the reduction in public debt was modest as the reduced value of private claims was matched by a sharp increase in Greece’s borrowing from its official creditors.
Yet, even if Greece had been given real and significant relief on its public debt, it cannot return to growth unless its competitiveness is rapidly restored. And without a return to growth, its debt will remain unsustainable. Problematically, however, all of the options that might restore competitiveness require large real currency depreciation, but there are only four ways to achieve such real depreciation:
· First, a sharp weakening of the euro. But this is unlikely as Germany is strong, the U.S. economy is weak and running twin deficits and the ECB is not aggressively easing monetary policy;
· Second, a rapid reduction in unit labor costs through structural reforms that increase productivity growth in excess of wages. But this is just as unlikely: It took 10 years for Germany to restore its competitiveness this way; and Greece cannot stay in a depression for a decade, until reforms start to have a real impact;
· Third, a rapid deflation in prices and wages, known as an “internal devaluation.” But this would lead to five years of ever-deepening depression, while making public debts more unsustainable as the fall in prices would increase the real value of such debts (the balance-sheet effect of debt deflation);
· Fourth, if the first three options are impossible, the only path left for Greece is an EZ exit: A return to a national currency and a sharp depreciation would quickly restore competitiveness, improve the trade balance and rejuvenate economic growth.
Of course, this process would be traumatic and cause collateral damage. That is why the exit has to be orderly and coordinated and financed by the troika. The current game of chicken between Greece and the troika is heading toward mutually assured destruction if the two sides don’t start to plan for an orderly exit for Greece. The troika is threatening to pull the plug on Greece but, if that were to happen and Greece were to default and exit in a disorderly manner, the losses would be massive, not just for Greece but for the rest of the EZ as well, as contagion could be huge. And since Greece knows that it has leverage over the troika, the latter should be willing to consider an orderly exit that is financed with official resources. An exit needs to be orderly, negotiated and properly financed to reduce the collateral damage to both sides.
Resolving the Problems in an Exit Scenario
Losses for EZ Banks and Investors
One of the most significant problems that would need to be addressed in an exit scenario would be capital losses for core EZ financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks and companies would surge. Yet, these problems can be overcome. Argentina did so in 2001, when it “pesified” its dollar debts. The U.S. actually did something similar in 1933 when it depreciated the dollar by 69% and repealed the gold clause. A similar “drachmatization” of euro assets and debts would be necessary and unavoidable.
Major EZ banks and investors, too, would suffer large losses in this process, but they would also be manageable if these institutions are properly and aggressively recapitalized and especially if the exchange rate at which euro claims are converted into new drachmas is agreed with the troika, rather than decided unilaterally by Greece. However, avoiding a post-exit implosion of the Greek banking system may unfortunately require the imposition of temporary measures such as bank holidays and capital controls—to prevent a disorderly run. On a temporary basis, depositors would be able to make payments within the banking system by using checks and transferring funds from one bank account to another, but they would not be able to withdraw cash—apart from amounts needed for modest cash-based transactions—from their deposits. Temporary bank holidays/deposit freezes are the necessary policy response to a bank run.
The necessary recapitalization of the Greek banks—necessary whether there is an exit or not—should be achieved via direct capital injections by the European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM) into the Greek banks rather than the current plan of having the EFSF lend to the Greek government, as the latter option makes Greece even more insolvent than it is currently. With a direct EU recapitalization of Greek banks, effectively the Greek banking system would be taken over by the EU tax payer, but this would be a partial compensation for the losses imposed on the foreign creditors by the drachmatization of euro liabilities owed to non-residents.
Restructuring Greece’s Public Debt (Again)
Greece would also have to restructure and reduce its public debt again, but this process also needs to be negotiated: The troika’s claims on Greece need not be reduced in face value, but their maturity should be lengthened by another decade and the interest on it lowered. This would be a form of debt restructuring in the form of a par bond: No face-value reduction for the time being, maturity re-stretching and a reduction in interest costs. Eventually, even the public claims—especially those pari passu with private ones such as ECB claims and EFSF claims—may need to be reduced and/or converted into drachma claims. Further haircuts on private claims would unfortunately be needed, starting with a moratorium on interest payments as a major haircut on face value has already occurred. Unfortunately, converting legal jurisdiction for the restructured claims from Athens to London and the credit sweeteners provided to private creditors may induce greater losses, mostly for official creditors of Greece rather than private ones.
Returning Greece to Growth
Some argue that Greece’s real GDP would be much lower in an exit scenario than during the hard slog of deflation, but this is logically flawed. Even with deflation, the real purchasing power of the Greek economy and of its wealth would fall as the real depreciation occurs. More importantly, via nominal and real depreciation, the exit path would restore growth right away, avoiding a decade-long depressionary deflation (Greece has already been in a recession for five years running). And trade losses imposed on the EZ by the drachma’s depreciation would be modest as Greece represents only 2% of the EZ’s aggregate GDP. Moreover, Greek imports are already collapsing as the economy is spinning into a deep recession and the previous regime of vendor financing has already imploded. So, trade losses for EZ partners are inevitable (regardless of whether Greece exits) and indeed necessary to restore competitiveness.
Moving to the Drachma
Moving to the drachma risks an overshooting of the exchange rate above what is necessary to restore competitiveness: The new currency could start to free fall once it is introduced even if the real depreciation necessary to restore competitiveness is more modest—say 30-40%. This overshooting would be inflationary and impose greater losses on the external claims of creditors as they would be drachmatized at a much weaker currency level. To minimize these risks, official troika resources currently devoted to the Greek bailout should be used to limit overshooting via FX intervention. Moreover, the imposition of necessary capital controls—a public debt moratorium, deposit freezes and other restrictions on the ability of private agents to convert drachmas into euros for capital account purposes—will also help to moderate the overshooting.
Those who claim contagion will drag others into the crisis are also in denial. Other peripheral countries have Greek levels of debt sustainability and competitiveness problems too: Portugal, for example, may eventually have to follow Greece in restructuring its debt and exiting the euro. Illiquid but potentially solvent economies, possibly such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, a self-fulfilling run on Italy and especially Spain’s public debt at this point is possible, if this liquidity support is not provided. The substantial new official resources of the IMF and ESM—and massive ECB liquidity—could also then be used to ring-fence these countries, and banks elsewhere in the periphery.
Secondary Effects of a Greek Exit
A Greek exit may have secondary benefits. For example, other crisis-stricken EZ economies would then have a chance to decide whether they want to follow suit, or remain in the euro, with all the costs that come with that choice. Regardless of what Greece does, EZ banks now need to be rapidly recapitalized. For this (as rightly suggested by the IMF), a new EU-wide program of direct capital injections in the stressed banks is needed, rather than using the EFSF to lend funds to national governments, as this choice would burden sovereigns with even more public debt.
More official resources would also be needed to finance the ongoing Greek primary and trade deficits. But since Greece is now close to a primary balance, such official support would be modest. Also, the sharp real depreciation that would follow an exit would rapidly restore a trade surplus in Greece; thus, official resources to finance the trade imbalance would be temporary and limited. The troika might not be happy to finance Greece to assuage the damage resulting from its exit, but the alternative of a disorderly default and exit would be just as severely damaging to the EZ periphery (with the risk of massive contagion), and would lead to financial chaos in Greece.
But even in Argentina, which received zero official support after its default and exit from a currency board, the external balance and growth was restored well inside a year. Argentina’s GDP was contracting at an annual rate of 15% in Q4 2001. But some eight months later, following a default (in late 2001) and sharp depreciation (which took six months from January 2002 until the overshoot was finished), it started to grow again, soon reaching a real annual GDP growth rate of 7-8%. While the recovery of strong growth in Argentina is a complex issue and some of it possibly not sustainable, the argument that Argentina got lucky because it was a major commodity exporter and commodity prices recovered after the exit is a red herring. At that time, most analysts wrongly argued that Argentina would not be able to restore its external balance because its exports were only 10% of GDP, but a sharp depreciation achieved its result in a short time. In Greece, exports are not 10% of GDP; they are rather close to 23% of GDP; thus, a sharp depreciation is likely to restore the external balance much more easily than in Argentina.
Moreover, the experiences of Iceland and many emerging markets in the past 20 years show that a nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness and growth. As in these cases, the collateral damage to Greece resulting from an EZ exit would be significant, but they can be contained.
It is better to have rules to make a separation less costly to both sides rather than sticking with a broken marriage that causes growing and severe damage both sides. Breaking up and divorcing is painful and costly, even when such rules exist, but an orderly divorceis less damaging than the alternative. Greece should exit the EZ, but remain a member of the EU, alongside those countries that opted out of entering the monetary union (the UK, Sweden and Denmark). The EU should not force Greece to exit the EU just because it leaves the EZ. If anything, the EZ should start designing plans for orderly exits from the monetary union of other members that do not qualify to stay inside the EZ.
Make no mistake, an orderly Greek exit from the euro would be painful and would cause significant collateral damage to Greece and to other distressed EZ members. However, Greece’s slow disorderly spiral into depression, bringing with it social and political chaos and violence, would be much worse.
1 RGE paper in September 2011, I advocated that Greece should exit the EZ, and provided detailed conceptual and analytical arguments on how to make this exit orderly. In this new paper, I elaborate on the policies and official resources