A Greek debt default wouldn't be a tragedy
Ross Buckley, UNSW
A poll of international investors last month found that 85% expect Greece to default on its debt this year. As market expectations go, that is very high.
Moody’s has since downgraded Greece’s already abysmal credit rating, and the European Union and the IMF are in the process of pasting together a second bailout package for the country.
How did the Euro come to this?
Well, from the outset, the adoption of the Euro had more to do with politics than economics. Experts knew a common currency for economies as disparate as Europe’s was going to be a huge challenge.
So Eurozone nations made binding commitments to keep their budget deficits below 3% of GDP, and their total debt below 60% of GDP.
The idea was that fiscal prudence would carry the day. But that proved hard to achieve: today 14 of the 16 Eurozone countries breach these targets.
But the bigger problem is the one nobody mentions – the relative competitiveness of economies. The modern drachma was introduced in 1954 at 30 to the US dollar and fell steadily in value. By the late 1990s it took 400 drachma to buy a dollar. This long slow devaluation allowed Greece to remain competitive.
Adopting the Euro ended the long-term trend of southern European currencies slowly devaluing against northern currencies, because the southern economies were less competitive.
If Greece, Portugal and Spain had their own currencies, market forces would mean they were worth much less than the Euro. If Germany had its own currency, it would be worth substantially more than the Euro.
So Germany’s massive trade surpluses arise partly because its undervalued currency makes its exports highly competitive.
There is therefore a structural problem in the Euro to which no one has yet developed a solution, short of Greeks becoming as hard-working, educated and focused as Germans.
Last March, when Greece’s problems first captured the headlines, the EU and the IMF needed to take tough action.
They needed to determine the amount of debt Greece could realistically service, and then demand Greece’s bank creditors write off the rest in return for the bailout loans that were extended to Greece.
So if Greece could service, say, 60% of its debts then the banks should, collectively, have been given a choice: either write off 40% of their loans and receive the bailout moneys that kept Greece servicing the rest of their loans, or retain the right to enforce the full amount of the loans knowing Greece would never be bailed out and the market would allocate losses.
Instead, the bailouts proceeded and replaced much commercial bank debt with sovereign loans from other countries. Bank shareholders were preferred at the expense of taxpayers in Germany, France and other countries.
The bailouts proceeded because the major creditors were German and other European banks. European nations were protecting their banks and the Euro.
Delaying the day of reckoning has made the problem larger, and its resolution far more difficult, as defaulting on bank debt is less difficult than defaulting on loans to other countries.
Meanwhile, the credit ratings of Australian banks were marginally downgraded last month because our banks raise a relatively large proportion of their funds offshore, and the expectation is that offshore markets will be thrown into turmoil later this year by troubles in Greece. The severe austerity measures imposed by the IMF and the EU last year were always going to shrink the economy, reduce the tax base and make servicing Greece’s debt even more difficult. And that is what has happened.
So where to from here?
One option is a prolonged default along the lines of Argentina’s in the early years of the last decade. Greece must be studying that precedent with interest, because overall Argentina emerged from it well.
It lost access to foreign capital for a number of years, but this was more than offset by its no longer needing to service its foreign debt, and its economy boomed. The default, when eventually resolved, led to major writedowns on its debt.
In one way this would be far easier for Greece than for Argentina, for the great majority of Greece’s loans are governed by Greek law, whereas Argentina’s loans were governed by New York or English law.
A short Act of the Greek Parliament could waive a sizable portion of all its loans if Greece has the political courage to withstand the resulting howls of protest.
Yet in another way, unless Greece leaves the Eurozone, this way forward is harder for it, as the devaluation that stimulated Argentina’s economy is denied it.
Outright default is less reprehensible than it might at first appear. The interest rates on loans to Greece reflected their higher risk. Now this risk has come home to roost, the banks want to be bailed out by the European governments.
But why should other European countries, most of which are already highly indebted, bailout the banks in this way? Why should not the market determine the losses?
However, just as it was politics that led to the Euro’s adoption, so it is likely to be politics that means Greece will choose not to default, and will be funded by other countries so it does not have to do so.
In the coming months, one can expect further bailout loans from other European countries, probably coupled to some of the haircuts on the debt by creditors that should have happened last year.
This will lead to some disruption and contagion in the markets, but far less than would be precipitated by an outright default, and the protests by Greeks suffering under austerity policies will continue.Comment on this article
Ross Buckley does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
UNSW Australia provides funding as a member of The Conversation AU.