My big fat Greek crisis

Greece is unlikely to be able to pay back its current borrowings. What cannot be paid back will not be paid back

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Not since the era of Aeschylus, Sophocles and Euripides has Greek drama enjoyed such popularity.

Audiences are riveted by provocative dialogue (immoral beggar; fiscal water boarding), tested themes (a Greek David versus a German and European Union (EU) Goliath), modish pop science (game theory) and sex (a Greek Finance Minister who attracts attention in equal measure for his economics as his appearance and sartorial choice). Financial markets watch passively, firmly convinced that the theatrical action on stage is entirely fiction.

The real short-term concerns are capital flight, the banking system and Greece’s current cash needs. Extensions and debt negotiations do not deal with the problem that Greece has insufficient revenue to meet its spending commitments. They merely defer the problems.

No good options…

Greece’s choices are fairly clear.

In the first option, the EU makes allowances. Maturities of borrowings, especially near term commitments, are extended. There are concessions on interest rates. Existing debt may be replaced with securities without maturity and a coupon linked to growth, so called Keynes-style Bisque bonds. The required primary budget surplus is reduced, perhaps with some new investment from the EU to boost activity. The ECB (European Central Bank) continues to support the liquidity needs of the Greek banks.

Despite the reduction in the economic value of the debt outstanding, the EU and lenders avoid a politically difficult explicit debt write-down. Syriza can claim to have fulfilled its mandate to stand up to the EU and Germany and reclaim Hellenic sovereignty and pride.

In reality, little changes. Professor Stephen Lubben has pointed out that the Bisque bonds are similar to securities used by the original J.P. Morgan to restructure insolvent American railroads in the Gilded Age. Many of these restructurings failed as the borrowers were left with unsustainable debt levels and were unable to obtain new financing.

Under this scenario, Greece and the EU are back at the negotiating table, within six to 12 months, confronting the same issues.

In the second option, Greece defaults on its debt but stays in the Euro, an option originally favoured by the current Greek finance minister when he was a mortal academic. It is not clear how a defaulted nation can remain within the Euro other than the fortuitous absence of an ejection mechanism.

Greek banks collapse if the ECB decides to withdraw funding. Capital flight accelerates, forcing implementation of capital controls. The Greek government is left with no obvious source of funding of its operations, other than a parallel currency or IOUs used during some government shutdowns in the US. Greece’s competitive position is unchanged as it purports to use the Euro. The EU and lenders incur immediate substantial losses on their loans.

In the third option, Greece defaults and leaves the Euro, replacing the common currency with new Drachmas. It defaults or its equivalent, repaying nominal debt in the new weak currency. Domestic banks have to be supported by the Greek central bank. There is short-term chaos. Activity in Greece collapses. The EU and lenders face the same problem as in the second option. In addition, the Euro is destabilised.

The third option allows Greece to regain control of its currency, money supply and interest rates. Sharp devaluation of the new Drachma improves competitiveness, for example, in tourism. The ability of the central bank to create and control money supply helps restore liquidity to the banking system and provides a mechanism for financing the government.

A cheap new Drachma, if appropriately managed, may reverse capital flight, as the threat of a loss of purchasing power is reduced. A devalued currency may help attract inflows of funds looking for bargains. In time, Greece regains access to capital markets as Russia did after its 1998 default.

Greece regains economic sovereignty but at the cost of reduced living standards as import prices sky-rocket and international purchasing power is diminished. But after the initial dislocation, and with the implementation of correct policies, a strong recovery may ensue.

The fourth option entails Greece caving in to EU demands, continuing with the mandated bailout terms and adjustment program, that is austerity. Syriza may be able to manage the backlash against its concession on the short-term extension. But continuing failure may result in internal and electoral problems, triggering a collapse of the governing coalition. In turn, new elections take place. Syriza may return with a specific mandate to default and leave the Euro.

Controlled warfare…

With around 85% of Greek debt owed to official lenders, Grexit would immediately trigger significant losses on bilateral government loans, ECB holding of bonds, the loans made by bailout funds and under the TARGET settlement system.  The total amount at risk is around €256 billion. The exposure of Germany, France, Italy, Spain, the Netherlands and Finland are €73, €55, €48, €33, €15 and €5 billion respectively.

Losses would convert off-balance sheet contingent guarantees into actual cash outflows. If Greece defaults, the EFSF, for example, will require each guarantor to make fiscal appropriations to cover any deficiency. The ECB may need to be recapitalised. The potential losses are significant relative to individual countries resources and budgets, especially for Spain, Portugal, Ireland, France and Italy which face their own financial problems. Covering shortfalls would make it more difficult for all nations to meet their EU mandated budget and debt targets.

Once Greece defaults and/or leaves the Euro, it would be difficult to stop speculation about other peripheral nations, undermining the entire basis for the common currency. Even without a full Grexit, any concessions to Greece would result in other countries such as Ireland, Portugal, Spain, Italy and France seeking relaxation on budgets and reform. Debt and fiscal sustainability within the Euro-zone would become unachievable.

There are now no more good options left for Greece. Whatever the outcome, the unwillingness of Europe to face reality means that problems will fester, dooming the continent to prolonged stagnation or worse.

This is an abridged version. You can read the entire column here.