A modest Greek proposal

 Greece may be facing a serious debt spiral. Governments of the Eurozone appears concerned for two reasons. The first and smaller reason is that many of their financial institutions may be exposed to Greek sovereign debt. A Greek default could therefore have repercussions across the Continent. In that sense, European governments are concerned for the same reason that the U.S. was concerned about Latin American defaults in the 1980s. This reason does not seem to be enough to account for all the concern.

The second reason is that they are terrified of contagion. We have a lot of evidence that investors panic and do bad things to good countries. (Consider the Argentine experience in 2001.) The Europeans might be terrified that a Greek default will drag down Portugal and Spain, possibly Italy and Ireland, countries that might muddle through in the absence of a panic-inducing shock. Large defaults would have two very bad effects. First, financial institutions in northern Europe are very exposed to their bonds; the risk of a super-1982 would be huge. Second, all of the PIGS right now are dependent on current borrowing to finance their government spending. If they defaulted, they would have no way to finance their deficits. Demand would collapse, plunging those countries into depression and dragging their trade partners down with them. (There may be a third reason to worry that I am missing.)

I will admit, however, that I am not entirely clear as to why these worries for northern Europe would be less in the absence of a currency union. Presumably the model is that (1) a country with a depreciating currency is less likely to default on its debt; (2) the loss in value from a default will be higher than the loss in value caused by depreciation; (3) foreigners would have held less sovereign debt in the first place in the absence of single currency; (4) the country would have been able to borrow in its own currency; and (5) the hit to the net exports of the other eurozone partners will be less in the case of a big depreciation followed (hopefully) by recovery than it would be in a depression caused by Hooverism. That seems reasonable to me, but I am not sure that I have it right.

So what to do?  Bail Greece out, obviously, with some sort of temporary low-cost finance. The problem, of course, is whether Greece’s fiscal problems can be solved. Well, it does seem as though tax evasion and inefficiency are a big part of the problem. Even without the crisis, these were bad things, as the linked paper demonstrates.

Well, there is an organization with expertise in managing tax-collection ... Crown Agents. They have an entire department dedicated to it. It would certainly be more palatable to Athens to have the Crown Agents denationalized (if somewhat British-heavy) workforce managing Greek tax collectors than it would be to bring in, say, Germans.

It is time for the E.U. to call them in.

Comments

[Bernard Guerrero]

I like the list of items #1-5. It appears, to me, to be comprehensive. My own premature guess on the likely demise of the euro was based largely on #1 & #5, the expectation being that the next big recession would naturally put pressure on the weak hands in the zone to depreciate, which is how they traditionally handled slowdowns. I figured it would be Italy leading the pack, though.

[Noel Maurer]

I hope you haven't put real money on that bet! Then there really isn't any way to break up the eurozone that wouldn't be worse for everyone involved than toughing it out.

Of course, all the worry about sovereign debt is a sideshow --- sure, it seems likely that the five assumptions are true, and a Greek default would hurt people in Germany more than it would in the absence of the euro. That still doesn't mean that it will hurt them very much. As you yourself once said (I paraphrase) all the real stuff will still be there.

The real worry for the eurozone is Spain's depression. That has a sovereign debt aspect to it, but Spain's debt dynamics are fine as long as investors don't get the vapors. The problem is that the only way Spain's economy can recover is for their to either be a rapid spurt of productivity growth or what they call "internal devaluation": e.g., slower price and wage growth than its primary trading partners.

That will be brutal. Less so than for countries with shakier banking systems, but pretty brutal. At least it will be as long as the ECB considers 1% inflation an acceptable outcome. Raise that to 4%, and Spain could do considerably better.

Still, even there, breaking up is hard to do. Consider Argentina's macroeconomic performance in 2002, and that was much easier, since the country still had a peso to devalue. You'd wind up reproducing the nightmare of 2001 --- when the economy was reduced to barter --- only to wind up with something far worse than 2002 because (unlike Argentina) you'd lose in European courts and lack a convenient commodity boom to rescue you.

Hard to imagine any government choosing to pull out in the absent of riots in the street ... heck, even with riots in the streets.

I should do a post about de-dollarization.

[Noel Maurer]

Here is a good explanation of why the eurozone won't break up.

[Bernard Guerrero]

"Then there really isn't any way to break up the eurozone that wouldn't be worse for everyone involved than toughing it out."

Quite probably true, but I don't see what that has to do with it. :^) No money on the bet, though. I ran into the site when doing a research project on the EU and optimal currency areas and put in a WAG based on when I thought the next Big One would hit. To be frank, I pictured a Smaller One than what we got, so I'm impressed with the performance to date.

The riots in the streets have already been happening in Greece on and off for some time, though. It will be interesting to see whether political fortitude remains if there's a ramp up in such activity.

On "all the real stuff will still be there": http://www.theonion.com/content/news/u_s_economy_grinds_to_halt_as

[Noel Maurer]

Hah!

Here's the thing about riots and the eurozone --- any attempt to exit will make the riots much much worse.

For months. Maybe years.

It's all flipped on the head from a devaluation, where a country retains a currency to devalue. Introducing a new currency would take fortitude, not staying the course.

The "easy" way out would be default, followed by some sort of rich-soaking.

[Randy McDonald]

This crisis might be the sort of thing that forces the Eurozone to approach considerably more closely the ideal of an optimal currency area, at least insofar as political integration and coordinated fiscal policies go.

[Bernard Guerrero]

Randy,

I don't see any groundswell in favor of more "automatic stabilizers" or transfer payments. Quite the opposite. Who gains politically from advocating for transfers to the PIGS or eastern Europe?

My mental model of the process requires that these steps be taken before crisis rather than during. Right now, it's just trying to sail upstream.

[Randy McDonald]

The Greek statistical adventure seems to have encouraged the lagrer, and wealthier, and stabler Eurozone members to demand higher standards of the non-core Eurozone members, at least, demanding stringent reforms and better statistics and even suspending certain elements of Greek sovereignty. If this sort of thing can be institutionalized past this crisis, it could be the sort of crisis-triggered response that works.

Hmm. How many other inter-jurisidction fiscal stabilization measures have popped up in times of crisis, or at all? I'm aware of Canada and Australia's schemes, apart from the EU. Does the US have anything equivalent?

[Noel Maurer]

Not the way you mean. In fact, federal revenue-sharing exacerbates the effects of budget downturns on core state budgets.

On the other hand, Medicaid, UI, and a few other programs work in a countercyclical fashion. In addition, there are direct transfers to citizens, like food stamps and TANF, which go up more the more depressed an area is.

The net effect is quite countercyclical. You read my post on Texas? Check out the graph.