Let Greece Have Its Default

Greece is rightfully making headlines these days, hovering on the edge of what would be a quite embarrassing default – an open admission that the country will not be able to pay back its staggering debt.

While such an admission would cause turmoil, and probably a career change for several politicians, it remains the least harmful of available options.


The core problem is debt, massive amounts of debt. The debt-to-GDP ratio of Greece is well above 100 percent, estimated to hit 124 % in 2010 and 131 % in 2011. While Greek economical estimates are notoriously unreliable (more on that later), this is plenty bad enough. For no plan exists to actually pay back that mountain of borrowed money.

There are plans to cut government spending, and these spell hardship for the Greeks, who are not among the most prosperous of Europeans in the first place. However, Greece has been systematically overspending since joining the eurozone, lured by easy access to loans backed by the European Central Bank (ECB).

The ECB will, no questions asked, provide banks fresh loans with sovereign debt as collateral. The banks can borrow relatively freely based on this mechanism, and will obviously be purchasing sovereign debt for the purpose. This decreases interest rates for the states, which is obviously attractive. Thus, the ECB not only constitutes a 'Lender of last resort' for banks, but for states as well, and that at rates so favourable that the 'Last resort' element has faded into the background and borrowing through this mechanism has become routine. Anatole Kaletsky wrote a hilarious article on the subject, How the ECB's fig leaf has completely withered away.

But debt remains debt, and no amount of money can, in the long run, cover up lack of production and productive work. Greece is a bad example of this. But first, let's look at some problems.


Problem # 1: Greece was not qualified to join the euro

When Greece originally applying to join the European common currency, the euro, few took it seriously. A tradition of deficits, devaluations and extensive corruption seemed to rule out the idea of Greece joining the club of sound economies participating in a common, sound currency.

To widespread surprise, Greece soon posted drastically improved figures for deficit, and projections that the situation would improve further, not least if permitted to join the common currency. And while the rules technically outlawed Greek due to a deficit of 3.38 % of GDP, creative accounting and some leniency on the part of the other euro participant permitted Greece to slip in.


Problem #2: Greece misused the euro membership

“Noblesse oblige” - once you are member of a fine club, you need to show that it is justified, that you abide with written, spoken and unspoken rules.

Writtten rules are enclosed in the Stability and Growth Pact, which stipulates that deficit must not exceed 3 % of GDP and total state debt must not exceed 60 % of GDP. Regardless of the violations that other countries committed, Greece should have kept those goals in sight and pursued them.

Spoken rules include the expectation that the improvements in Greek economy that magically came about in the nick of time should continue. That was a clear expectation when Greece abandoned the drachma and implemented the euro. Unfortunately, these improvements were fictions, and the Greek economy returned to its usual slump, emboldened by the new-found opportunity to borrow money at artificially low interest rates.

Unspoken rules include not least that states should not take on more debt than they can service, even though loans be available. The point of lowering interest rates is not to indulge in debt, but to make burdens easier to carry, that deficits can become less and eventually be eliminated. The moral hazard that cheap loans would fuel reckless deficit spending was not an initial premise, just a fact on the ground. In particular in Greece. See also: The Bailout of Greece and the End of the Euro.


Problem #3: Rules for the euro are not strict

This is well known by now. In particular in order to make Germans abandon their beloved and very functional Deutschmark, a firm promise had to be given that the euro would not be printed in excessive amounts, that member state deficits would be firmly under control, that no member country would misuse their privileges under the system, and that no bailout packages would follow from euro membership.

Each and every item above has been violated.

Now, there is no reason to believe that the rules of the Stability and Growth Pact will ever be firmly enforced. Once broken, each and every country can justify more exceptions, more violations, and refer to others committing similar breaches. The Pact, as it stands now, is holier than a Swiss cheese. Yet it was said initially, at the creation of the euro, that the criteria were paramount for ensuring the stability of the new currency. Were the politicians lying back then, or are they hiding something of the utmost importance now? Probably the latter.


Problem #4: The ECB produces money out of nothing

As above, a special mechanism exists for expanding government debt for the countries of the eurozone. This is probably deliberate, for easy access to loans at attractive rates makes it easier for states to engage in deficit spending, and gives much more headroom than in a free market economy, where states would only be able to borrow money based on actual savings, and would have to pay the interest rate that the owner of the money demanded, no exceptions possible.

The Keynesian philosophy on this is to dilute existing money with freshly created sums from the central banks. Through using the authority of the central banks, it is possible to create fresh money that is functionally equivalent to money resulting from hard work and saving, and this ensures that central banks never run out of money, no matter how much they lend.

This mechanism was endorsed by Keynes to avoid the arduous situation of having to work and save first, invest later. Through always having sufficient money at hand, countries – and the European Union in particular – could put themselves in situations where investments could be made without the need to save money first, making systematic stimulus of the entire economy possible.

There are some problems here. The investments thus made tend not to be profitable, the stimulated economy overexploits human and natural resources, and while the central banks will indeed never run out of money, the money tends to run out of value when too much is printed.


Problem # 5: The Greek bill is understated – again

The preliminary bill for 'saving' Greece has been estimated at € 45 billion. While this is, by any human yardstick, a staggering amount of money, it is probably insufficient. Greek productivity is tumbling, the country is politically unstable, and the welfare system is being swamped with illegal Albanian immigrants. Greece will be able to consume an incredible amount of money over the coming years.

A sum of € 45 billion will benefit current investors and permit them to get out of their Greek debt without too extensive damage. But with an annual deficit at around € 35 billion, that help is not going to last long, unless the austerity measures are hard enough to actually eliminate the deficit. Given the political situation in Greece, that can be ruled out. Rather, the other countries are now to help Greece with up to € 120 billion, according to IMF.

This constitutes a bait-and-switch approach that citizens in Germany, France and other countries footing the bill should not be expected to accept. Transferring €45 billion from people earning money to people losing money would be plenty bad enough, and a direct road to instability and ruin. Doubling or tripling that amount would make matters proportionally worse.


Problem #6: Moving money from producers to squanderers does not help

The whole bailout has a direction that does not make sense in the the long run: It will move billions and billions from the hands of hard-working, productive people to those who do not understand creating value and curbing consumption. Briefly speaking, this will not create wealth, it will create poverty. We should reward productive behaviour by letting the hard workers keep the fruits of their diligence, not pilfer it from them.

If we really were to make the European Union the most competitive zone of the world, as is the stated intention of the Commission, we would have to protect the profits of the entrepreneurs and create an environment much more conducive to enterprise and profit. This plan is nothing but a hollow statement of intent, and will likely fare worse than its predecessor, the Lisbon Strategy. Huge budgets make little difference here – the European Union would need to let free enterprise take on the task, or stop pretending that this is even remotely possible.


Problem #7: Bailouts create moral hazard

'Moral hazard' is the awkward situation where excessive risk-taking is encouraged through guarantees. If we guarantee that banks will never fail, they will by default engage in more risk than if bankrupts were a real possibility. Not so much due to 'greed' as to the simple fact that it is profitable to take relevant risks – that's in the nature of banking – and the better you manage the risk, the better your business does. If central banks and state guarantee – formally or informally – against severe losses, risk-taking is encouraged.

This goes for state actors as well. If Greece is rewarded for their debt addiction with more cheap loans, other countries like Portugal, Spain and Italy will have less incentive to cut back deficits, and will find it harder to convince voters that spending money they do not have is a bad idea. This sets the stage for more and larger bailouts in a year or two, and one wonders where the money is to come from.


Problem # 8: The risk of (hyper)inflation

Now, there exists an infinite supply of money in the eurozone, namely the ECB. Through extremely low interest rates and lending with sovereign debt as collateral, the ECB lets the money supply grow a rather significant 10 percent annually, and has done so for years.

In a situation where bailouts would grow from double-digit to triple-digit billions of euros, the only practical way to produce that amount of money is through simply printing it. That would snatch the value of the already existing euros from everyone holding euro-denominated assets, enrich the states and the financial sector, impoverish citizens, pensioners and not least the producing part of the economy, whose only access to money is to earn them through production and trade.

In that situation, inflation will bite. Double-digit inflation seems already to be in the wings. Some have talked of hyperinflation, but that will only take place if the central banks print that amount of money. If they don't, we can stick to normal, ruinous debasement of the euro.


Problem #9: The IMF is inflationary

Part of the Greek bailout package is to be supplied by the IMF, who is already busy pushing Germany to pay up (as reported by The Guardian). This is a wholly unacceptable behaviour, for IMF is no country, has no production, and has only the money granted to it by member state, either through contributions or through their own money-printing mechanism, Special Drawing Rights (SDR). They should not dictate behaviour of sovereign states not requesting help from them.

The SDR is an artificial currency composed as a basket of other currencies. It is composed of 44 % US $, 34 % €, 11 % Japanese Yen and 11 % British £. Technically not a currency, it is a potential claim on other currencies, but is used directly in some contexts, such as international postal services.

But while it technically is a non-currency, in practice it is yet another fiat currency. The creation of SDR's, such as the SDR 250 billion allocation in April 2009, constitutes money-printing and dilutes the value of every other currency. Thus, Japanese and Australians will contribute to bailing out Greece through the IMF, even though no resolutions or laws are to be passed in their parliaments.


Problem # 10: Devaluation is not an option, thus default is

In the old days, crappy and irresponsible countries such as France, Italy and Greece, would write down their currencies as needed. This would write down debt burdens, stifle imports, stimulate exports, and was generally seen as a somewhat fraudulent way to escape the consequences of overspending, as usual at the expense of the less well off in society. The alternative – an honest default on sovereign debt – was rarely seen.

Now, the euro was to put an end to this, and it does. Devaluation is no longer an option for euro member states, for they are not in control of their currency, the ECB is. Devaluation, even when sorely needed, is technically impossible. Thus Greece and other countries are forced into a situation of severe economical stagnation in order to service the huge amounts of debts they have taken on trough cheap ECB lending. This moves practical control of the burdened countries to ECB and Brussels. This may be in line with the EU goal of a European superstate, but has never been an openly stated objective.

Since Greece does not have the option of devaluation, the only other technical solution is an open default. This is a direct consequence of the European Monetary Union, one that was not stated at its creation, but follows logically from its function: If states can no longer dodge well-earned defaults through devaluations, taking the default becomes a more likely outcome.


Problem # 11: Sovereign debt is overrated

While it has been true for decades that sovereign states rarely do an open default, it is still rarer that sovereign debt, once reaching problematic levels, is honestly repaid. Denmark managed to do so for its large debt burden, but that was in great part due to the North Sea oil. Most countries honour the debt in numbers only, but not in value, through eventually paying back in devalued currency units.

Now, devaluation is not an option in the eurozone, and thus sovereign debt should be better than ever, given that it is backed by tax revenues of the issuing nation. Unfortunately such revenues can – and do – decline.

What was not announced at the creation of the euro is that it brings back the real risk of defaults. That is a Good Thing, for without a real risk of defaults, risk-taking is endless, and reckless government spending will ultimately destroy the entire economy by outcompeting the productive branches with newly printed ECB money. The full stop for this development is the default, and a Greek default is now fully earned and deserved. Yet, politicians and central bank managers are struggling frantically to avoid this.

If the real risk of sovereign debt was honestly calculated, investors would take on much less of it, in turn reducing state deficit spending significantly, and improving financial stability.


Problem # 12: None of the above is being properly addressed

It is depressing that not a single of the above issues is being properly addressed by our politicians. They all seem to seek a compromise that will defer the crisis for a while, in preference over admitting that the euro is a bad construct, kicking out Greece or working seriously towards a withdrawal, which in particular Germany could do to significant effect.

The most obvious, honest solution would be to give Greece an ultimatum: Either budget deficits are eliminated entirely within one year, the euro membership will be terminated. That would be real medicine, and restore real confidence in the Greek economy if executed. However, even though the idea has been floated in places, this is unlikely to become official EU policy.

Instead, a compromise is sought, as usual. Germany is playing tough, also due to pending elections, but will probably cave eventually, redoubling EU-sceptic sentiments in the country and widening the gap between citizens and politicians. This gap has been widening for quite some time, but there is bound to be a breaking point. Reaching it would be ugly.


Solution: Let Greece have its default

The only honourable way out of this mess is for Greece to default on its debt obligations. Foreign investors will run for cover, austerity measures will come by themselves, but this makes more sense than the Greek handing over more control to EU, ECB and IMF. Further, it would constitute a warning to Portugal, Italy and Spain to get their houses in order, and to investors that lending money to government may not be the wisest thing to do. Thus, drop the bailouts, let Greece default.


To devalue or not, that is the question

1) There are only two theoretical solutions possible: (a) devaluation (which in the case of Greece requires leaving the Euro), or (b) fiscal adjustment in Greece in order to restore investors' confidence in Greece's ability to service its debt.

2) In practice, what will likely be done is a "bailout" by outsiders (EU governments and/or IMF).  This can only make sense if it is done in a way that guarantees solution (b), i.e. Greek fiscal adjustment.  Ultimately this is a political decision, and if it will be an unserious one (i.e. one that does not bring about Greek fiscal adjustment), it will lead to even greater problems down the road. 

3) I agree with the author that letting Greece default on its debt is more likely to lead to Greek fiscal adjustment than further bailouts would. You do not heal a drug addict (in this case Greece's politicians and public sector unions) by providing more drugs (or money).

4) I disagree with the author on item 8. It is simply not true that there exists an "infinite money supply in the eurozone". While the determinants of the money supply are multiple and complex, including the demand for money, the supply of money is not 'unconstrained'. There are also no serious signs of "hyperinflation" anywhere in the eurozone. In fact there are signs of deflation in some cases. Recent rapid growth in monetary aggregates was a response to a sharp decline in the velocity of circulation of money, not a reflection of any desire on the part of the ECB to have an "infinite money supply". Money is an instrument, not a goal. Money has no value in itself. Its value derives from, or depends on, what money can buy.

5) I only agree partially with the author on item 9. The original purpose for the creation of the IMF was to prevent trade wars, by providing temporary foreign exchange to (external deficit) countries experiencing balance of payments problems (usually due to some external shock). That is very different from problems resulting from ever-growing public debt burdens, as in the case of Greece here. If Greece should be bailed out, it should be done by its fellow eurozone members, not by the IMF. The euro is not "foreign exchange" in Greece, and the IMF should treat Greece as it treats California (i.e. it should ignore it). However, I disagree with the contention that the IMF and/or the SDRs of the IMF are "inflationary". They could be, but don't have to be. In fact, the IMF is more often than not assocated with claims of being deflationary, i.e. that the conditionality of its (temporary) loans - requiring fiscal adjustment - has an initial 'contractionary' impact on the economy (both in 'real'/volume and in'nominal'/price terms). However, given the growing power of the international left in and on international institutions, it is possible that the role of the IMF is changing. The SDR is a 'reserve asset' on the balance sheets of central banks of countries. Its purpose is to deal with international liquidity problems between countries, not to increase domestic money supplies of individual countries. The latter, as mentioned, will be determined by many factors. While it is true that each country's SDRs will be a small part of its 'foreign reserve assets', and thus a small part of its monetary base, this will not play any significant part in the mind of the monetary authorities when they make monetary policy decisions with a view to achieve domestic price stability.

'Infinite' is wrong

Marcfrans, you are right about the term 'Infinite' being wrong with regards to the euro money supply fromt the ECB. The correct term is 'Unlimited' - I refer to Kaletsky for details.

That does not change the substance of item 8, however. I specifically discount the risk of hyperinflation, but maintain that we will have double-digit inflation soon, as in a couple of years' time. Manipulation of the CPI might disguise the fact, though.

As for item 9, I maintain that the IMF is today basically inflationary due to the way SDR's are issued. That the IMF simultaneously will impose economical sanity to the countries helped, and thus help curb consumer price increases is a different and useful aspect, but does not change the inflationary nature of the SDR.

The above are not causes for concern among our politicians or in the mainstream media. I think they should be.

"Devaluation, even when

"Devaluation, even when sorely needed, is technically impossible."

That is the core of the problem with the "common currency". It is simply unnatural that countries like Greece or Portugal have a stronger currency than the USA or one equal to Germany, even if they were much better off than they are today.
Of course Greek elites were happy to join the euro, because this gave them easy access to cheap credit for a decade, so that they didn't have to make any serious attempt to reduce public expenses and get their house in order, but where did this leave their economy? Tourism is supposed to be a key contributor to their national income, but why visit Greece when e.g.Turkey is 1/3 cheaper? Even for Euro members it isn't much of a choice, let alone Americans.

Crappy northern countries

To the list of "crappy and irresponsible countries such as France, Italy and Greece" who devalued their currencies in "the old days", you might add Norway.

During the late 70's and early 80's, Norges Bank – the national bank – would devalue at the drop of a hat, up to several times a year, as I remember it. A bit of a charade, where unions yearly threatened with strikes, the socialist government putting on a show of resistance (only to soon cave in to organised labour's demands), then afterwards cleverly pulling the rug out from under their constituents a few months later through the insidious tool of devaluation, leaving everyone back at square one, holding a currency with lowered purchasing power.

I suspect that Norway was not alone in doing this among northern European nations at the time.


Does this 'default' theory apply to any capitalist country? Even on UK or USA? I would be surprised, if you would honour their debt obligations the same way. So, come on EU, eliminate budget deficts in 1 year - great!