The Greek Crisis: Uttering the Other "D Word"

Matías Vernengo

Default is not the dirty word that nobody wants to say.  Almost everybody now accepts that Greece will default.  Several people will prefer to use the euphemism of “re-profiling debts,” but we all know what it means.  The interesting thing is that at least some authors, like Martin Wolf in a recent Financial Times column, also acknowledge that default is not sufficient.  The surprising thing that almost nobody asks is whether a default would actually solve the Greek problem.

Of course that would require understanding the problem in the first place.  And herein lies the problem, since most people still argue that the Greek problem is fundamentally fiscal.  In other words, in the conventional view the Greek government spent too much (and lied about it), and the solution must rely on the generation of sufficient fiscal surpluses to pay for the outstanding debt.  Further, to obtain the funds it is assumed that austerity is the way to go, privatizing public firms, cutting public sector wages, and reducing pensions.

Note that the cuts in spending hit public investment and social transfers, two items with relatively large multiplier effects which are sure to have a significantly large negative impact on output, and, as a result, on government revenue.  This is why fiscal austerity is self-defeating.  In Argentina, back in 2001, Domingo Cavallo tried to adjust the fiscal accounts with the “zero-deficit” law that prohibited the government from spending more than it raised in taxes.  The de facto economic laws that say that declining income reduces revenue took precedence over the de jure law, and Argentina had a budget deficit of around 6.5%.

Beyond that the only contribution of austerity to resolving the real issue, which is related to the large current account deficits (as I noted in a previous post), is that austerity restricts imports.  But austerity can only resolve the current account at the price of permanent stagnation and worsening fiscal balances, without creating capacity to repay outstanding debt.  So it is clearly not a solution, and, as correctly pointed out by Krugman, the Argentine example actually shows that default is necessary.

However, it is important to emphasize that default, although necessary, is not sufficient for economic recovery in Greece.  It is true that Argentina (and Iceland, for that matter), did very well after their defaults.  But Argentina also devalued its currency after more than a decade of a fixed nominal exchange rate peggedto the dollar.  The current account switched swiftly from deficits to surpluses, and combined with boosting exports and the recovery of domestic activity, fiscal revenues increased, leading to an improvement of the fiscal accounts.  Further, a strong renegotiation of the debt allowed for lower levels of indebtedness, so that fiscal consolidation resulted not from fiscal austerity (which actually failed) but from economic growth.

Most analysts fall short of mentioning the other dirty d-word, devaluation, because this would imply a break of the eurozone.  Yet, if default is inevitable, but insufficient to resolve the Greek dilemmas, no other alternative remains.  There are those who suggest that a move towards a more comprehensive European Union, boosting transfers from a larger European fiscal authority would be part of the solution.  Or even that Germany should increase its real wages and boost spending to reduce its current account surpluses, to make the adjustment in the peripheral countries less painful.  But those seem clearly out the question.  Neither Germany nor the European Central Bank (or the IMF) seem to be willing to break from the austerity plan.

Holding to the euro, and accepting the austerity measures, is fundamentally a mechanism to punish the Greek population, and transfer resources to German banks.  The euro, like dollarization in some Latin American countries, generates more problems than solutions.  I said it before: the euro is dead.  Greece should decide how long they will tie its future and the welfare of its own people to a failed model of monetary integration.  Tragedy may be a Greek invention, but there is no reason for the government to force its own people to live through it as a sort of morality play.

5 Responses to “The Greek Crisis: Uttering the Other "D Word"”

  1. Rudi von Arnim says:

    Agree! A few comments: First, it’s not only a transfer to German banks, it’s as well a transfer to anybody who has the cash to snap up Greek state assets at firesale prices. Second, the most astonishing part of the story is how incredibly bad reporting on the issue in the international media is. Many Germans — and I just come from there — still think — because their politicians and newspapers tell them so — that the problem could be fixed with austerity and “bail-outs.” Third, the so-called bailouts aren’t any. So, the only thing that could make default-cum-devaluation avoidable is a fiscal transfer from Germany and France to Greece, and possibly all PIIGS. Anything else points towards (1) years of pain in Greece, (2) ultimately Greece leaving the Euro and (3) contagion leading to the break-up of the Euro. I heard the arguments that some Euro-leaders will realize that the costs of the break-up are too high, and hence, will support the German-periphery transfer — but I don’t really believe it.

  2. Agreed. German(and I could have said French too) banks is just a simple way of suggesting that a lot of the money from austerity goes to save the banks that made the crazy bets. Not very different than TARP in the US.

  3. […] Matias Vernengo: The Greek Crisis: Uttering the Other “D Word” (27.6.11) […]

  4. It is my understanding that a not-insignificant component of this is private Greek bank debt, and if that is the case, it would seem to me that a nationalization/liquidation of the banks will also ultimately be required. More argument, as far as I am concerned, that banking is just too dangerous to be left to the bankers, and should become a public function, run very transparently and very conservatively. I live in Costa Rica, where nearly everyone maintains most of their cash in one of the four state banks, because the private banks that compete with them seem to have a habit of frequently going out of business. No one trusts the private banks, and with good reason.

    The other component not being considered here is public spending. It is well understood that the three public investments required for a country to grow over the long term are health, education and infrastructure. By forcing the Greek economy into penury, where these investments cannot be made, is a sure formula for making Greece into a third-world nation. Is that really what the European Union wants? Somehow, I can’t think they can. Therefore, default, devaluation and bank restructuring are the only way out. Anyone at the IMF who has had experience dealing with third-world currency crises could have told you that. But when it is OUR oligarchs that are going to have to take a haircut, no one seems to want to listen.

    What does this tell us about who really runs the show?

  5. […] Greece. Indeed, Argentina has experienced impressive growth alongside debt restructuring. But as others have pointed out, the two cases are not all that comparable. One additional reason for Argentina’s swift […]