Greece’s Catch-22 situation, is there any easy way out?

Reducing its debt needs inflation, restoring its lost competitiveness needs deflation. Greece is toast and should consider leaving the euro…
Greece has two near intractable economic problems:

  1. Greece’s public finances are unsustainable, with the public sector deficit above 13% of GDP and public debt above 100% of GDP
  2. Through years of higher inflation rates compared to it’s trading partners, it’s economy has become uncompetitive (the accumulated inflation differential is at least 30% or so)

There is a third problem in the form of a nasty trade-off. Addressing one problem tends to make the other problem rather more intractable. Some inflation is needed to get the debt to manageable levels, but inflation will worsen the already severe competitiveness problems of the economy. Debt is a nominal figure, inflation eats into that by reducing its real value. For instance, inflation is how Great Britain got rid of a debt/GDP ratio approaching 300%(!) after the Second World War.

On the other hand, restoring competitiveness through sustained low (or negative) inflation will make the debt that much more difficult to treat (ask the Japanese, their debt/GDP level is almost twice that of Greece).

How did it ever got to this state?
This is rather simple. In the 1990s, Greece wanted to join the euro that badly that it cooked the books. Once Greece was in, fiscal discipline was relaxed (to put it mildly), the huge decrease in interest rates as a result of the entry fuelled a borrowing and spending boom.

As a result of that spending boom, prices kept on rising faster compared to its euro trading partners so the economy lost competitiveness and current account and public sector deficits kept on growing. All this happened under a fixed exchange rate system (and fixed exchange rates do not come any more ‘fixed’ than giving your currency up and adopting another one, in Greece’s case the euro), the results are entirely predictable.

Latin American history is littered with examples of this. Tying currencies to the US dollar (in order to guide inflationary expectations downwards), but keeping loose fiscal and monetary policies, tepid structural reform of the economy at best (or outright hostile stance against exporters at worst), it all in one or another way describes periods of most Latin American economies, whether Mexico, Brazil, Colombia, Argentina (Chile has been the rare exemption). This always ends in tears. Always. Lately (and perhaps most spectacularly) in Argentina 2001-2.

Like Argentina, Greece never took the trouble to reform its economy to address the competitiveness problems. Instead it just partied on the relative economic boom created by the low interest rates that were the result of adopting the euro. The fundamentals of that boom, shaky from the start, were rapidly eroded. Then the world financial crisis did the rest.

What now, Ireland or Argentina?
There basically two avenues in front of Greece, which we could call the Ireland or the Argentinian option. The first (the Ireland option) involves remaining within the eurozone and going to a long and painful path of reigning in the public sector and (like Ireland did in the late 1980s) structural reforms in the economy. The Argentinian option would involve (just like Argentina in 2002) a large devaluation and debt default.

Both options in front of Greece will lead to further economic pain for the foreseeable future. Ireland is making unprecedented cuts in its public sector as we speak (involving wage cuts up to 20% for some public sector workers). Although the Irish economy was partly based on two bubbles (in finance and real estate), it is way better positioned than Greece’s economy.

Ireland’s economic miracle from the late 1980s was based on a similar crisis as it’s facing now. So dire was the situation that consensus was forged to embark on a rather bold reform package, freeing up the economy, improving the education system, and creating a very friendly regime for foreign export manufacturers to set up shop in Ireland. 

These measures had rather spectacular results. From a European basket case, Ireland emerged as the ‘Celtic tiger,’ with Asian growth rates. In a decade and a half, Ireland moved from the bottom of the European economic league tables to the top. In the end, it also led to excesses in real estate and finance (unfortunately, the Irish economy this century was increasingly based on those two sectors which were in the eye of the storm of the financial crisis).

But unlike Greece, Ireland has already gone through turmoil like today’s. There are little street protests in Dublin as a result of the draconian economic measures. There is no visiting IMF or European credit line. By and large, people and policy makers know what is required, and display a business like way of going about it. Despite the excesses in real estate and finance, the economic base of the Irish economy is also fundamentally way more sound compared to Greece.

Greece’s ‘Ireland route’ is considerably more complex still. Apart from having to make similar cuts in the public sector, it has the additional task of making deep structural reforms to make economy more competitive. Ireland has already largely done that from the late 1980s onwards. And all this while not being able to dispose (like Ireland when it reformed it’s economy two decades ago) of it’s own monetary and exchange rate policy.

This is an unfathomably difficult task, even if the public would be behind such measures, which is something we don’t see (or not yet anyway). Like we explained above, Greece cannot count on even a mild form of inflating some debt away. Because of it’s euro  membership and the accumulated inflation differential (some 30% or so) vis-à-vis most trading partners, it has to have sustained lower inflation to restore its competitiveness. Which makes dealing with debts and deficits that much harder.

It’s not surprising there are many who look for an easier way out. Which brings us to the ‘Argentinian option.’

As the saying goes, it’s much easier to change a single price (the exchange rate) than all other prices. Where the Ireland option involves a protracted process of having to change all wages and prices (to restore competitiveness), an Argentinian 2002 style devaluation could restore competitiveness at a single stroke.

Greece would have to leave the euro in order to do that. The ensuing financial panic would make a  debt default unavoidable (just like Argentina did in 2002). Many protesters on the streets of Greek cities would consider that an additional bonus. Even denominating its outstanding debt in newly (devalued) Greek drachme would amount to a de-facto default (and we’re glancing over some thorny issues and finer details of getting rid of the euro and having to reintroduce the old currency).

At a stroke, Greece would have at least temporary relief of its two most pressing problems, getting rid of crippling debt levels and restoring competitiveness. Even better, this solution doesn’t involve nasty trade-offs between addressing these. Instead of a highly deflationary reduction of public expenditures and increasing taxes, it could give its economy at least a temporary boost by leaving the euro and (re-)introduce a much cheaper currency. It’s easier to embark on difficult reform when you don’t have to sink your economy even further.

For instance, the Argentinian economy recovered rather well after the devaluation and debt default in 2002. Initially, there was such a large output gap (the difference between the potential output and it’s actual output) that even the very large devaluation did not cause much inflation (at least not initially). But Argentina benefited from having rapidly increasing demand (and prices) for it’s main (agricultural) export products this decade.

Although law of comparative advantage shows that with a large enough devaluation, some products and services always become competitive, but  somehow we don’t see an immediate Greek equivalent of Argentinian soya beans or its other agricultural export successes. These products faced such booming demand and price increases that Argentina, as one of the few countries in the world, can even tax these exports at significant rates.

But Argentina under the Kirchners wasted golden opportunities to reform it’s institutions and economy. Because of the favourable demand for its agricultural sector, it can sort of stay afloat (albeit inflation has taken of in a serious fashion and the country is becoming ever more expensive) even without such reforms, but that’s about as good as it gets.

Lacking a killer export hit, Greece would not have that luxury. So even this ‘Argentinian option,’ what seems like an easy way out of two intractable and partly mutually exclusive problems, isn’t so easy after all. Greece would still need to embark on reforming it’s economy in a serious fashion. Devaluation and debt default provide but a temporary window of opportunity.

They cannot afford to waste such opportunity, as they wasted the windfall from joining the euro in 2002. By joining the euro, Greece eliminated a devaluation risk and it had credible monetary policy at a stroke. This gain without pain was wasted by not reforming the economy, not keeping it’s public finances in order, and accumulating large inflation differentials vis-à-vis its trading partners.

Without reform, at best Greece would end up where it was before it joined the euro, with it’s economy having many structural problems, its monetary policies lacking credibility (now with the added infraction of a default) and having to pay much higher interest rates on its debt because of default risk, lack of inflation fighting track record or credibility, and devaluation risk. One could argue, credibly, that such a Greece would actually want to join the euro again!

So leaving the euro would bring temporary relief, but no reprieve from having to embark on seriously reform its economy. The devaluation would make exports more competitive and hence the recession would be milder, but without reform, this would lead to rising inflation and interest rates sooner or later (ask the Argentinians).

Unravelling of the euro area?
Funny enough, the incentives for the rest of Europe to bail Greece out won’t be blunted all that much if Greece leaves the euro. This is because European banks hold the larger part of the of outstanding Greek debt (some 400 billion euro). European politicians would be once more faced with the awkward dilemma of having to chose between it’s electorate and its bankers. And as we know by now, the bankers usually win.

This might lead one to think that Europe wouldn’t mind all that much if Greece leaves the euro. But that is a mistake. The all to real danger is that the financial markets will perceive it as the beginning of the unravelling of the euro area.

If it’s easier for Greece to deal with its debt and competitiveness problems outside the euro (at least at first), the same logic applies to countries which have much the same problems, like Portugal, Spain, Ireland, or even Italy. Because of the sheer magnitude of outstanding debts of these countries, even partial default is not an option as it would bring the whole financial system down.

If these countries would leave leave the eurozone, a core of like minded countries would remain. Funny enough, this would be a eurozone much like Germany always wanted before the euro was born. But today, they would not be in favour of that.

Germany has done very well in the euro area as they did embark on (moderate) structural reform which allowed the German economy to gain in competitiveness especially against the producers from the countries that might now thinking of leaving. Although trade is not a zero-sum game, their loss of competitiveness was at least partially Germany’s gain.

So, what’s going to happen?
Greece will plod on, helped by credits from the IMF and other European countries terrified of the consequences of a default and the contagion effects. Greece will think (or, more accurately, hope) that with a reform package with the stamp of approval of the IMF and Eurozone, it could get interest rates on its debt back to more manageable levels.

But even if this happnes, Greece’s problems are of such magnitude, the solutions to its problems so contradictory, and there are so many ways in which all of this could easily derail, we think it’s highly likely it will only be postponement of execution. Sooner or later, the phantom of Greece defaulting and/or leaving the euro area will raise it’s head again..