The fear of Grexit and Greek default continues to hang by a solitary hair of a horse’s tail over global financial markets like the Sword of Damocles. This is, in essence, a battle between the past and the future, between the nation state and globalising forces.
The eurozone question virtually hijacked the agenda of G20 leaders at their sixth summit in France in November 2011. A band-aid was put on the sore. The can was kicked down the road through bailout packages that bought time rather than resolution. Over three years later, the crisis continues to fester despite the proverbial can being kicked down the road several times, effectively transferring liabilities from private creditors and banks to official creditors.
The latter now stand to lose the most from Greece defaulting on its debt.
The continuing crisis in Greece is but a symptom of the wider problem, namely birth defects in the design of the Economic and Monetary Union (EMU) of the EU forged a little over a decade and a half ago. These fatal flaws were well known, but the union was more a political than an economic project.
A monetary union has several advantages, just like any large integrated economy, such as the US or the Indian federation. However, as Robert Mundell pointed out over five decades ago, it needs at least four essential features to be optimal—capital mobility; economic integration that makes for synchronised business cycles so that there can be a single monetary policy; labour mobility; and automatic fiscal transfers ring-fenced by hard budget constraints.
With constitutional restrictions on the constituent state’s borrowing powers, the US and India by and large fulfil these requirements. The eurozone does not.
With the benefit of hindsight, one could perhaps add two more essential ingredients. One, a banking union that cuts the umbilical cord between banks and constituent countries. With operations across multiple countries in the union, the assets of several European banks exceed the gross domestic product of their sovereigns, making them too big to be bailed out.
Two, convergent productivity that makes for an equitable exchange rate. In terms of the Mundell-Fleming Framework, each country or state in a monetary union is subject to a common exchange rate and capital mobility, but does not have monetary independence. The European Central Bank (ECB) sets monetary policy in the eurozone.
In such a situation, nominal rather than real wage adjustments are necessary to improve competitiveness. This is always politically difficult.
Greece joined the EMU in 2001. Its borrowing costs fell sharply as the drachma gave way to the much stronger euro, a reserve currency, allowing it to increase consumption. Its current account deficit shot up from 3-4% of GDP to over 5% almost immediately. Its external deficits kept rising and exceeded 10% by the eve of the global financial crisis, peaking at around 15%. The story was repeated in Spain, Portugal, Ireland, other members of the PIGS club.
Meanwhile, Germany went from a deficit to a surplus that consistently exceeded 5% of GDP. The same exchange rate led to vastly different outcomes in the two countries because of productivity differentials and poor labour mobility.
The euro did not depreciate because the eurozone as a whole was balanced. PIGS deficits were countervailed by northern surpluses.
What happens when a country persistently runs large current account deficits? One is tempted to conclude that as external liabilities accumulate as a consequence of the need to finance these deficits, a point would be reached when the confidence of those financing the deficits would disappear. At first the cost of financing would rise through credit downgrades, further exacerbating the deficit; then, when the Minsky moment comes, external confidence crashes altogether and the currency collapses as market access is lost. This is exactly what happened to the clutch of eurozone countries described by the colourful acronym PIGS. Greece is the most extreme example, but Grexit can be expected to spillover to other vulnerable countries in the eurozone.
Textbook Macroeconomics 101, one might say? Except that the outcome depends very much on where you are coming from. The above sequence of events would surely happen if you were a developing country, resulting in a localised, or at worst a regional crisis like the East Asian Crisis of 1997. But the global economy and financial markets would carry on as usual. However, if you are the issuer of the global reserve currency, the large external demand for the currency might ensure that the Minsky moment never arrives, despite any credit downgrade that rating agencies might make. This is what happened to the US and the dollar during the global financial crisis. The IMF had long warned of a global financial crisis stemming from a disorderly unwinding of US current account imbalances and resulting in the collapse of the dollar. The financial crisis did occur, but not in the manner forecast. When global financial markets went into a tailspin, the ensuing flight across the board actually strengthened the dollar despite the source of the crisis emanating from the US.
Even if there were a Minsky moment for the US, and the dollar were to collapse and borrowing costs to rise, it can always avoid a technical default because the debt it owes to non-residents is denominated in its own currency. There is no difference between its external and domestic debt. Sovereigns can always print their way out of domestic debt. This might cause macro-economic instability, but a default can be avoided.
Greece’s debt is also denominated in its domestic currency. However, since it does not have monetary autonomy, it cannot print its way out of default, or depreciate its currency to match its productivity. Only the ECB can print the euro. In such a situation, fiscal transfers are required to avoid default. The absence of such a mechanism is the biggest birth defect of the eurozone.
Technically speaking, Greece has not voted for Grexit in the recent referendum. It has voted to reject a compromise with international creditors. Grexit and international pariah status, and possible expulsion from the wider 27 member EU, is nevertheless likely. The vote will be interpreted as wilful default, especially since it has already defaulted on IMF repayment, and because the biggest creditors of Greece are now official, the IMF, the ECB and the sovereigns of the bigger eurozone countries such as Germany, France, Italy and Spain. Their politicians, and in particular Angela Merkel, are likely to suffer politically from the fallout of the Greek crisis.
What the eurozone politicians were trying to do was shut the stables after the horses had bolted by denying debt restructuring or/and further assistance to Greece. It is their taxpayers who stand to lose most from a Greek default.
European politicians are complicit in bailing out private creditors and banks who lent recklessly and transferring their liabilities to taxpayers without being forced to take haircuts. Now the taxpayers will be forced to take the haircuts because Greece cannot repay its debt in full.
At current growth rates, Greece had little option but to default on its liabilities without harsh and painful reforms.
Merkel, the most influential European leader, recognises this and is willing to consider debt restructuring provided this results in effective fiscal and banking union. This would mean a hard budget constraint on constituent states through curtailing of sovereignty. It would, at the same time, once and for all correct the birth defect of the eurozone.
With euro funding ending, Greece has little option but to exit the eurozone and restore the drachma. This would mean a great deal of front-loaded pain for the Greek population, but will it lead to another international financial crisis? Ironically, despite all the post-crisis attention on financial institutions too big to be allowed to fail, neither the global financial crisis nor the eurozone crisis emanated from too big to fail entities. The US sub-prime housing market was a relatively small segment of the very deep US financial markets. Greece is less than 0.5% of the global economy. The greater danger lies in contagion.
In the case of the global financial crisis, opaque, complex structured financial products distributed through shadow banks made it impossible to determine on whose balance sheets the defaults would show up. This led to a generalised risk aversion in global financial markets and a credit freeze.
In the case of Greece, it is quite clear where the risks lie. The earlier bailouts transferred major Greek exposures to official creditors—Germany, France, Italy, Spain, the IMF and the ECB. But there are several slow-growing eurozone economies with high levels of sovereign debt that can be serviced only as long as interest rates remain low. A Minsky moment can change all that. As borrowing costs increase, existing levels of debt would look increasingly unsustainable. Any contagion from the Greece crisis can snowball beyond the PIGS to expose Italy and even France.
The only way this can be prevented is by the ECB stepping up its QE programme and buying bonds of weaker eurozone countries.
Grexit might give Greece immediate fiscal and exchange rate flexibility to kick-start a recovery, but at the cost of great front-loaded pain. My best guess is that despite the IMF default and the referendum, the can will somehow be kicked down the road again to buy more time. The eurozone is, however, skating on thin ice. Sooner or later Grexit, and more, seems inevitable unless all stakeholders in the eurozone project summon the political will to fundamentally redesign it to move towards greater fiscal and banking union, which implies a further curtailment of sovereignty. The future of globalisation, and all the efficiencies and welfare benefits it brings in its wake, is at stake. Other nascent regional groupings, and above all the G20, are watching with bated breath.
The author is additional chief secretary, Planning and Economic Affairs, Government of Kerala