Can the Grexit Lemon Be Made into Lemonade?
With a referendum scheduled for Sunday and frantic negotiations spilling onto the front pages, the possibility of a Greek exit from the euro area, or Grexit, looms large. It is hard to see how Grexit could be avoided if the referendum results in a "no" vote. Such an exit is fraught with danger, yet it also holds hope for stronger economic growth in Greece over the next few years.
The current government in Greece does not instill much confidence in its ability to handle the technical challenges of Grexit. Indeed, Grexit would be disruptive even under the most competent and experienced of administrations. To achieve the best possible outcome to leaving the euro area, the Greek government will need to overcome three critical challenges. First is the technical and logistical challenge of converting contracts, payrolls, bank deposits, loans, and securities from euros into drachmas and introducing new paper currency in drachmas. Second is the challenge of dealing with potential bankruptcies of Greek banks and corporations that have borrowed in foreign markets. Third is the policy challenge of maintaining the hard-won fiscal balance and communicating that commitment successfully to the public and to financial markets to avoid a massive jump in inflation. If these challenges are overcome at least moderately successfully, the Greek economy could begin to grow within six months and accelerate strongly over the next two or three years. The question remains whether this or any government can overcome these challenges.
The first step would be to enact legislation to convert all financial assets and liabilities and all commercial contracts and wage agreements issued under Greek law from euros to drachmas at par (one for one). Banks would need to close for at least a couple days, possibly more, to reprogram their systems. Legislation would also specify the introduction of drachma notes and coins at the earliest possible time, perhaps within six months.
The drachma would be allowed to float against the euro as soon as the banks reopen. It would surely depreciate, probably by a lot at first and with considerable volatility before settling down. It is impossible to predict how much the drachma would depreciate; in Iceland's experience, the financial and debt crisis of 2008 caused an initial depreciation of nearly 40 percent that has since stabilized at around 25 percent in real (price-adjusted) terms. The euro notes and coins currently circulating in Greece would increase in value. During the months before drachma notes and coins are introduced, euro notes and coins would be used for small purchases, with merchants accepting them at the market-determined premium.
Government debt held by Greek financial institutions would be converted to drachmas at par. These institutions would be required to accept new government debt for principal and interest payments coming due. The government would declare a moratorium on principal and interest payments on the rest of its debt, including the debt of the Bank of Greece to the European Central Bank. Negotiations would begin on a restructuring of this nonconverted debt.
Balance Sheet Issues
The challenge that is least amenable to policy response, competent or otherwise, is the risk that banks and corporations that have borrowed in foreign markets would be unable to repay their debts. This is a risk for domestically oriented companies whose revenues would be converted to drachmas while their foreign debts remained fixed in euros. According to data from the International Monetary Fund (IMF) for year-end 2014, Greek private external liabilities were $156 billion, or 64 percent of GDP. This is considerably less than Greek private external assets of $229 billion, but the problem is that many of the borrowers may not have external assets to cushion the blow.
The government would be forced to recapitalize any systemically important bank with an excess of foreign liabilities over foreign claims. Given that the government has essentially no usable foreign assets, it would have to give the bank drachma bonds, which would worsen pressure on the exchange rate as the bank sought to convert its drachma to service its euro debt.1 Other private institutions with external debt might be forced into bankruptcy, which has severe costs for the economy.
A bright spot is that drachma depreciation would have a large positive effect on the net external position of the private sector, which owns a lot more euros than it owes. Euro for euro, the negative effect on spending by debtors exceeds the positive effect on spending by creditors. However, the creditors have far more euros than the debtors owe, so the net effect is not clear.
The immediate increase in the cost of imported goods combined with the jump in value of euro notes and coins would cause drachma prices to rise. This price increase would further reduce living standards, but in a widely shared manner. A competent government would contain this initial price rise to around 10 or 15 percent through several measures.2 First, and most important, the government would affirm the statutory independence of the central bank, with job security for its governor and a mandate to achieve 2 percent inflation over the medium term. Second, the government would commit to maintaining a balanced budget indefinitely. Third, salaries of public workers and public pensions would be limited to 2 percent annual increases in drachma terms.
The real depreciation of the drachma would cause an immediate boost to spending inside Greece that would grow over time. It would make Greece more attractive to international tourists. It would boost the domestic buying power of employees and owners of the large Greek merchant marine who earn their money overseas. It would increase the competitiveness of Greek farmers and oil refiners and others that produce goods for export. By making imports more expensive, it would boost the competitiveness of Greek firms that make competing products and services.
Few forces are more clearly demonstrated in economic history than the boost to spending and growth from a large and sustained real depreciation. Successful stories of large fiscal adjustments almost always include large real depreciations. The reason that fiscal austerity has proved so damaging in Greece is precisely because its membership in the euro area makes real depreciation difficult to achieve.
What Could Go Wrong?
The Greek financial system cannot operate under the threat of potential Grexit. Currently the banks are closed and the economy is already paying a high price. If the government wins a "no" vote in Sunday's referendum, it should keep the banks closed while rushing through the necessary legislation on Monday. Any delay will necessitate keeping the financial system on lockdown longer, increasing the economic damage. Infighting and disagreements among ruling politicians and officials could prevent the dissemination of a clear and coherent message to the public. Lawsuits by citizens and affected foreigners raise huge and uncertain risks. To the extent that Greek firms with foreign debts differ from those with foreign assets or foreign revenue streams, a large number of bankruptcies is possible, which could seriously delay the return to economic growth.
Probably the biggest risk is of uncontrolled inflation. After five years of austerity, Greece achieved a primary fiscal balance last year.3 However, the current government is already falling behind on tax collection, and it will be sorely tempted to reverse some of the draconian spending cuts of recent years. Greece will be shut off from international borrowing and its government will find it very difficult to borrow domestically. If the government does not maintain a balanced budget for the foreseeable future, the temptation to take control of the central bank to fund its deficit through money creation will be irresistible. Indeed, even a widespread perception that the government is likely to abandon fiscal balance could be enough to create a burst of inflation that the central bank would be forced to fight with high interest rates that could choke off economic growth. Greece's history of relatively high inflation prior to joining the euro does not bode well for its credibility in this endeavor.
1. IMF data show that the government had $45 billion in external portfolio assets and $4 billion in gold at year-end 2014, but it is likely that the portfolio assets are not usable because they may be pledged as collateral or have other restrictions. If not, Greece would not be forced to default right now.
2. Inflation in Iceland rose by 7 percentage points for two years after its depreciation in 2008 and then returned to its pre-crisis average.
3. An unresolved issue is whether Greece's net subsidy from the European Union budget would be reduced or eliminated after Grexit.