Brexit? How About Grexit?

Introduction

The debate over whether the UK should/will leave the European Union continues. The same question should be asked about Greece leaving the Eurozone. Remember Greece? That was the country that encountered some economic turbulence right after the global depression resulting from the US bank collapse in late 2008. It the reason the Eurozone has not yet recovered (current overall unemployment rate of 10%) to this day.

The Eurozone was a bad idea. It forced countries with quite different cultures to play by the same economic rules. It meant that if Italy and Greece were not as productive as Germany, they would end up running large balance of payments deficits. Why? Because they could not compete on world markets at the same exchange rate as Germany. And if you do not think having the exchange rate as a competitive adjustment mechanism is not important, consider the US. The dollar weakened relative to the yen from ¥360/$ in 1971 to ¥120/$ in 2015. That meant a dollar would only buy only a third as much from Japan as it did in 1971. Conversely, yen holders could buy dollar products for only one third as much as they did in 1971. In short, this adjustment allowed the US to remain competitive with Japan.

The Greek Bailouts – What Has Happened To Date

The first bailout program for Greece was in 2010 for €110 billion. An IMF “Stand-By” provided €30 billion (27%) and Eurogroup countries contributed €80 billion (73%). In 2012, it was cancelled after €73.7 billion had been disbursed. It was replaced by a new IMF Extended Fund Facility (EFF) and additional Eurogroup support. The EFF was to provide quarterly payments of €6.2 billion into 2016 totaling €28 billion, provided Greece achieved numerous qualitative and quantitative performance targets. The Eurogroup promised €144 billion over the 2012 – 2014 period. And finally last summer, the Eurogroup agreed to a third bailout agreement in July worth up to €86 billion without IMF participation.

In addition, back in 2011, Greece and its creditors agreed to what was effectively a 75% debt reduction. Additional support for Greece has been provided by the European Central Bank (ECB). The Bank has been buying Greek debt to keep rates from skyrocketing.

Policy Differences

Throughout all of this, the relationships between the key players – the Greek government, the Eurogroup, and the IMF – have been strained. Greece has not been willing to take the various policy steps the other two are demanding. The Eurogroup wants more austerity while the Fund says more austerity would be counter-productive. The Fund insists that Greece’s debt burden needs to be reduced. At this point, the real battle is between Germany and the IMF over these two issues.

a. Rift 1 – Austerity

In 2010, the IMF developed an austerity program for Greece. It projected Greek unemployment to be 13.1% and 13.4% in 2011 and 2012, respectively. These projections turned out to be horribly wrong. Actual unemployment figures were 17.9% in 2011 and 24.4% in 2012. These unemployment jumps were caused in part by the draconian reductions in Greek government deficits demanded by the IMF/EU combine. Table 1 provides data on this point. Note the reduction in the Greek government deficit from 2010 on along with the GDP decline/unemployment increase.

Table 1. – Greece: GDP Change, Unemployment, Government Deficit

Source: IMF

In 2012, Oliver Blanchard, the chief economist of the IMF and another IMF economist, reviewed the IMF’s earlier research findings on the unemployment effects of reducing government deficits. They concluded the earlier unemployment multiplier estimates were too low. Their new research suggested that a 3% fiscal consolidation would result in as much as a 1.8 percentage point increases in unemployment. But even this doubling of the unemployment multiplier does not explain the huge unemployment expansion in Greece. The Greek economy was in a free fall.

To its credit, the Fund saw what was happening in Greece and gave up on austerity. This caused a serious rift between the IMF and Germany as Germany and several other Eurozone members have insisted that austerity should be the primary policy vehicle to solve Greece’s problems.

b. Rift 2 – Debt

The IMF has repeatedly said The Greek debt (188% of GDP) is unsustainable, but the Eurogroup and Germany in particular have shown little interest in dealing with it. To get a better understanding on these issues, the following quotes come from the just-released IMF Greek Debt Sustainability Analysis (DSA).

“The government has not been able to mobilize political support for the overall pace of reforms that would be required to retain the June 2015 DSA’s still ambitious assumptions of a dramatic, rapid, and sustained improvement in productivity and fiscal performance. In all key policy areas—fiscal, financial sector stability, labor, product and service markets—the authorities’ current policy plans fall well short of what would be required to achieve their ambitious fiscal and growth targets.”

The Eurogroup wants Greece to achieve a 3.5% budget surplus in coming years. The Fund’s report continues:

With tax compliance rates falling precipitously and discretionary spending already severely compressed, staff believes that the additional adjustment needed to allow Greece to run sustained primary surpluses over the long run can only be achieved if based on measures to broaden the tax base and lowering outlays on wages and pensions, which by now account for as much as 75 percent primary spending. Recent discussions have confirmed that there is little evidence of political support for such measures, and the proposed automatic mechanism triggering ex-post across-the-board spending cuts is not an effective substitute for durable reforms. This suggests that it is unrealistic to assume that Greece can undertake the additional adjustment of 4½ percent of GDP needed to base the DSA on a primary surplus of 3½ percent of GDP. In view of this, staff believes that the DSA should be based on a primary surplus over the long run of no more than 1½ percent of GDP.”

On debt:

“The revised projections suggest that debt will be around 174 percent of GDP by 2020, and 167 percent by 2022. Gross financing needs cross the 15 percent-of-GDP threshold already by 2024 and the 20 percent threshold by 2029, reaching around 30 percent by 2040 and close to 60 percent of GDP by 2060.”

In short, these debt levels are not sustainable. Since 2010, the Eurogroup has lent funds to Greece via three mechanisms: the European Financial Stability Facility (EFSF), the European Stability Mechanism, and the Greek Loan Facility (GLF).

The Fund recommends:

An extension of maturities for EFSF, ESM and GLF loans of, up to 14 years for EFSF loans, 10 years for ESM loans, and 30 years for GLF loans could reduce the GFN and debt ratios by about 7 and 25 percent of GDP by 2060 respectively. However, this measure alone would be insufficient to restore sustainability.”

Payment deferrals: EFSF loans have already been extended before, and ESM loans have been provided with long grace and maturity periods. Extending the deferrals on debt service further could help reduce GFN further by 17 percent of GDP by 2040 and 24 percent by 2060, and—by allowing Greece to benefit from low ESM interest rates for longer—could lower debt by 84 percent of GDP by 2060 (This would imply an extension of grace periods on existing debt ranging from 6 years on ESM loans to 17 and 20 years for EFSF and GLF loans, respectively, as well as an extension of the current deferral on interest payments on EFSF loans by a further 17 years together with interest deferrals on ESM and GLF loans by up to 24 years.) However, even in this case, GFN would exceed 20 percent by 2050, and debt would be on a rising path.

To ensure that debt can remain on a downward path, official interest rates would need to be fixed at low levels for an extended period, not exceeding 1½ percent until 2040.”

These recommendations are going to be very tough for the Eurogroup to swallow. They go far beyond what they have said they are willing to do.

The Eurogroup could move ahead again without the IMF’s involvement. But German Chancellor Merkel believes only if the IMF is involved. Her position stems largely from the fact that only the IMF’s staff is capable of monitoring Greek compliance with whatever terms are agreed to.

Concluding Thoughts

“Noise” from the discussions between the Greek government, the IMF, and the Eurogroup will continue. There will be more leaked transcripts and other evidence of fundamental differences. At some point, the German government, prodded by its citizenry, will have to consider whether it wants to keep bailing out its weak southern sisters – Greece, Portugal and Spain.

And how much longer will it take Greece to realize it cannot compete in the global economy if it has to use a currency whose value depends primarily on German productivity?

Grexit should happen sooner than later.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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