Greece faces death by a thousand cuts unless it leaves the euro

 

By Jeremy Warner, Associate editor 7:32PM GMT 13 Feb 2012

Lucas Papademos was suitably apocalyptic. If the terms of the second Greek bailout were not approved, the Greek prime minister warned over the weekend, there would be a "disorderly bankruptcy that would create conditions of economic chaos and social explosion.

A pedestrian walks past graffiti covering the entrance to the central bank of Greece following demonstrations in Athens on Sunday. Photo: Bloomberg

"The savings of the citizens would be at risk. The state would be unable to pay salaries, pensions, and cover basic functions, such as hospitals and schools, and … the country - public and private sector alike - would lose all access to borrowing and liquidity would shrink.

"The living standards of Greeks would collapse. The country would drift into a long spiral of recession, instability, unemployment and prolonged misery. These developments would lead, sooner or later, to exit from the euro."

Up to a point, these warnings are of course all true. Much less clear is whether the enforced penury of continued euro membership which Greek MPs eventually voted for on Sunday night amounts to a better alternative. Any analysis of the economics suggests powerfully that it does not.

Now it is certainly the case that once in the euro, exiting it is not a path any government would willingly contemplate. Without the second bailout of €130bn, Greece would not have had the money to redeem the €14bn of bonds which fall due on 20 March. The resulting default would mark the start of a process of national bankruptcy which in the first order would mean state pensions, wages, contracts and medical bills not being paid. From there, the insolvency would multiply outwards into the already deeply impaired private sector, where many businesses would find it impossible to stay afloat.

To exit the euro would further savage the private savings market, much of which would be wiped out by devaluation and cascading bankruptcy. An immediate, and violent economic contraction would occur, followed in short order by a likely inflationary tsunami.

 

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The first wave of the inflation would come from devaluation, the second from compensating wage demands, and the third from a central bank forced to monetise the still yawning budget deficit.

It is no surprise, then, that Greece's technocrats, backed by a substantial majority of its existing politicians, have turned their back on such a course.

But is it really any worse than the one chosen? Repeated rounds of austerity are proving self defeating, which makes it virtually certain that Greece will eventually have to come back for more. What are Europe's paymasters to demand then?

That ordinary Greeks be further punished for the sins and omissions of the old political and business elite? They've already been driven close to open rebellion. Morally and socially, it cannot be right to push them any further. To keep on demanding more is no longer an economic strategy, but a form of sadistic vindictiveness, designed, perhaps deliberately, to back the country into a corner.

What is more, experience in Argentina and other countries that have both devalued and defaulted suggest that the economic shock of exiting a fixed exchange rate is relatively short lived.

Once competitiveness has been restored by devaluation and default, growth prospects improve dramatically. The short sharp shock of exit is very likely better than the death by a thousand cuts implied by continued membership.

Consider now what this grim choice of death by a thousand cuts involves. What Greece has in essence committed itself to is an internal devaluation lasting years, if not decades into the future. There is no discernible end to the austerity; year after year, it grinds remorselessly on. Even if everything goes according to plan, which seems deeply unlikely on the record so far, it takes until 2020 to reduce the national debt to 120pc of GDP, a level still far too high to be remotely sustainable.

In addition to having to run big primary surpluses into the indefinite future, Greece also faces a massive hit to nominal wages and living standards as it seeks to impose competitiveness on an economy which in truth has about as much in common with the colder, northern climes to which it has joined itself at the hip as the Mediterranean does with the Baltic. To think that the two can ever be moulded into a unified whole is fantasy of the cruellest kind.

There is not a hope of Greece growing its way back to debt sustainability while still in the euro. As things stand, capital is leaving the country by whatever means available, sometimes stuffed into suitcases and spirited across the border.

It may be deplorable for the country's rich to be running scared in such numbers, but it is also an entirely rational response to a crisis which might at any moment destroy what little capital that remains.

No business can survive in such an environment. Not until Greece devalues, and Greek assets start to look reasonable value once more, will the money return.

Yet instead, Greece has chosen the internal devaluation route, or the forced reduction in wage and asset prices necessary to restore competitiveness. Does anyone other than the technocrats and the hair-shirted Germans really think such a road possible?

In less extreme form, much the same hard labour awaits the rest of the eurozone periphery, which must similarly achieve big reductions in real exchange rates via the socially destructive path of decreases in nominal wage and asset prices.

Put another way, to restore competitiveness the European periphery must endure an inflation rate way below that of Germany and the rest of the single currency core into the indefinite future. Since Germany is unlikely to tolerate inflation of much more than 2pc, most of these countries are effectively condemned to deflation, or depression, stretching years into the future.

Even if that were the right thing to be doing from an economic perspective, it seems intolerable from a political and social one, as we are already seeing from the mini-revolution on the streets of Athens. Public support for the political establishment is going up in flames. The euro is destroying the very fabric of Greek democracy. Others can only look on in fear of what may await them too.

Even within the technocratic governments that enthusiastically embrace the new fiscal compact, there have been stirrings of rebellion. Mario Monti, the Italian prime minister, has warned of the dangers of pushing governments too far, and fearing contagion to his own country, has asked for Europe to go easy on Greece. Yet on the whole, they stick to the Tina (there-is-no-alternative) script. We've tried devaluation in the past, they say, and all it does is provide a way of avoiding difficult and ultimately necessary structural reform. The euro forces us to do things we've always ducked in the past. Our future lies in a unified and competitive Europe, not in the irresponsible protections and conflicts of history.

These are noble sentiments, but also slightly strange ones, for they imply that countries don't trust themselves to enact the necessary labour market, social, capital and legal reforms unless under the cosh of Berlin. Devaluation is not the coward's way out, nor is it a substitute for the sort of structural reform Greece and others so plainly and desperately need.

But what it does do is smooth the adjustment and take the edge off its socially and politically malicious consequences. It's a natural market mechanism both for correcting imbalances between nations and for settling how to share the burden of external indebtedness. The present approach threatens only mutual destruction.

Greece faces death by a thousand cuts unless it leaves the euro - Telegraph