Does Greek default mean Greece leaving the eurozone?

by on September 15, 2011 at 2:17 am in Economics | Permalink

I get this question a lot; by the way this guy advocates one and not the other.  “Not necessarily, but probably” is the answer.

Let’s say Greece opts for a large default.  The Greek government’s commitment to the Greek banking system could then be seen as either stronger or weaker.  Stronger because they have more money left over, or weaker because they are breaking their commitments.  Note that Greece is still borrowing to meet current budget, so a large unauthorized default probably weakens the commitment to the banks.  They’re still out of money and then some.

In my view the commitment of the Greek government to its banking system needs to be seen as much stronger.  If perceptions remain the same or weaken, the silent run on Greek banks will continue or worsen.  Sooner or later, the Greek government, through guaranteed or nationalized banks, will be redeeming “a euro” for “less than a euro,” at which point they have de facto left the eurozone.  Remaining in the eurozone means making the bank redemption promise truly credible at a one-to-one rate.  Default makes that tougher rather than easier.

Even if Greece, after a large default, has enough cash to back its banks, the market still might be thinking Greece will leave the eurozone for optimal currency area reasons.  That will lead to a continuing exodus of deposits from Greek banks.  It’s not clear how the Greeks can stem that additional pressure and it means we’re again back to a weak Greek commitment to its banking system.  Leaving the euro means getting that pressure over with and beginning the process of Greek bank recapitalization, long and painful though it might be.

To sum up, I expect that default would lead to Greece leaving the eurozone, though you can write down conditions (more cash on hand for the government, consequences of default vanish quickly, stronger guarantee to banks, no subsequent fear of eurozone desertion) where that doesn’t have to be the case.

Peter Whiteford September 15, 2011 at 3:06 am

I don’t see how Greece can default before it leaves the eurozone. If it defaults who is going to lend it money? But it needs money (euros) every month to pay its civil servants and its pensions and its army, since its tax collections are insufficient to meet its obligations – with the gap around 10% of GDP. So if it defaults it has to start writing IOUs to its citizens. how long can that last?

Tomasz Wegrzanowski September 15, 2011 at 6:22 am

How much of its obligations is debt service? Once you eliminate that, what’s the gap?

Peter Whiteford September 15, 2011 at 9:06 am

According to http://www.voxeu.org/index.php?q=node/6553 the primary deficit (i.e. the deficit leaving aside interest on the existing debt) is about 5% of GDP.

Bob Knaus September 15, 2011 at 7:20 am

Why does Greece need Greek banks? When Florida banks fail, they get taken over by North Carolina or New York banks.

There is an easy scenario for Greek default while staying in the Euro zone. The Greek banks fail, they get taken over by German or French or whatever banks. The Greek government gets a banana-republic rate on new bonds for a few years, and loses the privilege of issuing Greek-brand euros. The Greek central bank gets turned into a museum.

How hard is that?

Greece September 16, 2011 at 7:56 am

very hard….

john haskell September 15, 2011 at 7:38 am

@ Peter Whiteford- the IOU’s will be called “drachmae.” How long can that last? Well Socrates made purchases in drachmae, so my guess is that arrangement can be continued for at least 2500 years. Maybe longer.

Peter Whiteford September 15, 2011 at 8:47 am

John Haskell

As I wrote on this site back in May, Greece cannot leave the Euro overnight. To leave the Euro you actually have to have a supply of coins and banknotes in your new currency. You also have to have your ATMS ready to dispense your new currency, the parking meters adjusted, your cash registers changed, all your payment systems ready and anything that either requires you to put in or take out Euros ready to do this in new drachma.

I think it took about 2-3 years to introduce the Euro as a “physical” process and it probably takes about the same to reverse the process.
.
People cannot live on IOUs for 2 to 3 years.

Bob Knaus – the problem isn’t with the Greek Banks – its with the Greek state (and the foreign banks)

Bob Knaus September 15, 2011 at 9:40 am

My point exactly. Greek bonds default, Greek and foreign banks fail (or not), the Greek government pays higher rates and loses seignorage privileges, the Greek people continue to use Euros. If the process continues to other countries, the Euro eventually becomes a Mark. Or perhaps a Frark.

The Anti-Gnostic September 15, 2011 at 9:50 am

I think you’re missing the real point: Greek bankers and Greek bureaucrats would see a decline in their living standards. That cannot be allowed to happen. We narrowly avoided such an awful fate in the US in 2008. We can only pray this awful contagion does not spread to Britain, France, Italy, Spain and Portugal

Roy September 15, 2011 at 10:13 am

But that involves robbing greek farmers, greek tourism industry, shipping industry and everyone who isn’t a greek bureaucrat or banker.

Greece has had a violent civil war in our lifetime, I suspect the greeks who will lose by losing euro just might object. Outside of Athens it could get extremely ugly.

The Anti-Gnostic September 15, 2011 at 11:19 am

No it doesn’t. It means the losses falling on people who’ve been mooching and the actual productive Greeks get more stuff for less work.

londenio September 15, 2011 at 12:19 pm

What needs to happen is that every contract needs to be rewritten in the New Drachma. By contract, that means salaries, deposits, mortgages, etc. The New Drachma is pegged at 2:1 (say). The ATMs can still provide Euros which will could be used as a means of exchange. Grocers and Hairdressers will still have price lists in Euros, but they will have to lower prices to get customers.

It will hurt (I was working in Argentina in 2000-2002).

Art Deco September 18, 2011 at 5:59 pm

The design of all Euro coins is local to the country of issuance. The design of the paper currency is identical across all countries, but on the obverse side is a serial number. Every serial number begins with a letter of the alphabet which indicates the country of issuance (in the case of Greece, “Y”).

Steven Kopits September 15, 2011 at 8:49 am

They’re out, and soon.

Greece September 16, 2011 at 7:57 am

very poshibol…

Greece September 16, 2011 at 7:58 am

very poshibol…

E. Barandiaran September 15, 2011 at 10:30 am

Tyler, regarding the Bloomberg piece, let me just say that it fails to point out that Mario Blejer was Argentina’s Central Bank VP since March 2001 and became its president in January 2002, so he was part of the team that prompted Argentina into the crisis of December 2001. He was part of the problem but not of the solution: he could keep his new position of president only until June 2002. Anyway if you are interested in Mario’s ideas I suggest that you read

http://www.voxeu.org/index.php?q=node/5326

http://www.bloomberg.com/news/2011-05-30/greek-day-of-reckoning-looms-in-ponzi-europe-mario-i-blejer.html

Regarding your analysis, you ignore (1) that default as a breach of contract usually takes place after a long process of negotiation has failed, and (2) that the idea of optimal currency areas has never been relevant to any political decision on the formation or the breakdown of currency unions.

To understand (1), it’s important to compare the historical records of defaults of private debts and sovereign debts in detail. Here, however, I can only share with you and your readers the lessons I’ve drawn from my professional and academic experience. In the case of private debts, the negotiation process is public only in rare circumstances (today example is Solyndra) and the public knows that something happened only when the debtor asks for the protection of the judiciary (in the old days, creditors asked the judiciary for protection of their interests). Most cases of private insolvency are solved by private negotiations in which creditors attempt to assess (a) the debtor’s ability and willingness to pay, (b) the losses they will have to take, and (c) alternative agreements to distribute the losses among themselves. In turn, during the negotiations, the debtor attempts to take advantage of his/her information about the state and prospects of his/her business. How long the process takes depends on the uncertainty about the business’ prospects, but more important on the relevance and reliability of the information shared between the two parties and the willingness of the debtor to release control of his/her business (a major problem in family companies).

In the case of sovereign debts, since the state will not be wound up, insolvency implies the urgency of changes in revenues and expenditures. The negotiation process between a sovereign debtor and its creditors doesn’t have the incentive of a third party (the judiciary) to put an end to it, but more important, the process is public and the debtor cannot ignore (a) its membership since the government is usually a coalition of politicians with their own personal interests, and (b) the many pressures from voters and a variety of organized groups (some supporting their interests, and other their values or their beliefs). In addition, the determinants of the failure or success of the private process mentioned above take a much higher degree of intensity in a negotiation of sovereign insolvency because –for all practical purposes– the reliability of the relevant information can hardly be verified by the creditors (one of the few services provided by the IMF is this verification but anyone familiar with the history of the relationship between Argentina and the IMF knows that it’s better than nothing but close to nothing). In sum, it takes a long time to make progress in negotiating an agreement between a sovereign debtor and its creditors. Only outsiders to the negotiation that know very little about what is going on will be willing to suggest “radical” solutions to end it on the basis of an urgency that gives them recognition (and celebrity?). If they were interested in understanding what is going on, they would be assessing progress in producing relevant and reliable information and in assessing (and re-assessing often) the ability of the sovereign debtor to pay back some of the debt and the ability of the creditors to take the losses.

To understand point (2) about optimal currency areas, you may agree with me that the world market economy is the optimal FIAT currency area if the relevant criterion is the standard economic one of scale under Friedman’s assumption of zero marginal cost of producing a fiat currency. Only by recognizing how wrong this assumption is, we can argue for a competitive supply of fiat currencies in the world economy. The old Mundell’s approach to optimal areas was based on a macroeconomics of stabilization that has shown to provide a poor understanding of how the world economy works and a useless foundation for stabilization policy (btw, I’m ready to argue that based on that macroeconomics, the optimal number of fiat currency areas would well be over one million, including a few thousands within the U.S.).

Finally, the suggestion that Greece will benefit from leaving the euro is based on the benefits of re-introducing a depreciated/devalued drachma. What have we learnt about devaluations? Most textbooks still discuss the allocative effects of devaluation, although most Argentine economists (following the early work of the late Carlos Diaz Alejandro) emphasize its distributive effects. The latter can imply a re-distribution from labor to capital, from creditors to debtors, or from the private sector to government. We can argue a lot about a devaluation’s allocative and distribute effects, but the main reason for Argentina to abandon the convertibility system of April 1991 was to redistribute income to the government because only by taxing agricultural exports the government could generate enough revenue to finance expenditures. Therefore, I’d like to know from anyone suggesting that Greece has to re-introduce the drachma what effects he/she expects from the devaluation and its complementary policies.

Guy in the Veal Calf Office September 15, 2011 at 12:14 pm

Europe is explained graphicallyhere. The absence of Italy and France speaks for itself.

happyjuggler0 September 15, 2011 at 1:49 pm

In my view the commitment of the Greek government to its banking system needs to be seen as much stronger. If perceptions remain the same or weaken, the silent run on Greek banks will continue or worsen

In my opinion you haven’t thought this through. If Greece defaults on its debt, people won’t lend money to the Greece government. You’d have to be an imbecile to do so.

So say Greece defaults. It immediately has to have a balanced budget, by default, since no one will lend to them. Now imagine people think that Greek banks will go under, and there is a bank run. How in blazes does Greece bail out depositors? The answer is that it can’t, it is going to have enough of a hard time figuring out how to balance a budget. If it chose to bail out depositors (i.e. bailout banks in mistaken common parlance), then it would have to cut spending by an equal Euro amount. I don’t see how that could be politically possible (it may even be mathematically impossible to begin with) to (in street parlance) “cut needed government services so as to bail out rich bankers”.

So the only way possible for the Greek government to “credibly commit to the Greek banking system” is to not default on its national debt in the first place. In order to do that, it would need to run budget surpluses right now, something that it isn’t doing and seems to have no desire to do.

Therefore you have a silent run on the banks right now, and the only mystery is why anyone would have any money at all in Greek banks. Greece is going to default, and Greek banks are all going to fail.

Chris September 15, 2011 at 5:51 pm

I agree with this comment. The only possible variant is where Greece defaults and either you get some form of co-ordinated ECB/euro intervention to recapitalise the Greek banking system, or else some solution where Greece retains the ability to borrow following default. This could either be continued loans from the IMF or EFSF (obviously senior to the defaulted debt!) or else some form of eurobond.

It is clear that the Greek banking system will be insolvent following a Greek default, so without one of these solutions no bailout would be possible.

Greece September 16, 2011 at 7:55 am

Not necessarily .If Greece has to do even more … bigger restructure

Greece September 16, 2011 at 7:59 am

Not necessarily .If Greece has to do even more … bigger restructure

Glaukus September 22, 2011 at 10:33 pm

Most of protests are Staged and very well Orchestrated, they pretend fighting but do not hurt each other. This is worth it to get hundreds of billions from EU. Greeks are very smart; the deception started with the Trojan Horse and is going on with very well orchestrated “PROTESTS”. If you want Greece to be paid off, for the Enormous Army, Universal Free Health Care, Lucrative Pensions, and Taxes that they never Pay, then you pay them by yourself, PAY THEM OFF, BY YOUR OWN POCKET.
DON’T LET GREECE TO DRAG YOU DOWN. CUT OFF THE ROPE, AND LET THEM GO FIRST…Because A fed bear is a Dead Bear.

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