What should Greece do?

Greece faces a stark choice: stay in the euro and implement the policies demanded by its creditors or exit and re-introduce its own national currency. The dimensions of this decision go far beyond economics, affecting Greece’s political and cultural identity for generations. Yet, even in a narrow sense – determining which option will lead to the best economic outcome for Greeks – the decision is complex and fraught with uncertainty.

In this post, we aim to clarify how the stay-or-go choice will influence Greek income and growth prospects. Our objective is to examine the principal factors that would influence this choice if it were based solely on economic considerations.

To get this out of the way at the start, we have long shared Barry Eichengreen’s view that a breakup of the euro would prompt the “mother of all financial crises.” But even without exiting the euro area, Greece already has borne a significant portion of the cost of a crisis that an exit would bring. Its banking system was closed for weeks and remains impaired following a severe and prolonged run. Deposit withdrawals are now sharply curtailed and capital controls limit the cross-border flow of funds.

Indeed, with Greek businesses increasingly unable to either make or receive payments, we assume that the economy has suffered another sharp setback in recent weeks – on top of the 26% plunge in real GDP since its mid-2007 peak. Moreover, Greece cannot return to healthy economic growth without fully restoring the confidence of households and businesses in the banks. Rebuilding trust in Greek banks will require a recapitalization that can only occur after a credible accounting for loan losses and a realistic evaluation of sovereign securities held by these intermediaries.

Similarly, in the absence of fresh resources, Greece can run neither a current account deficit (in which imports exceed exports) nor a budget deficit (in which government outlays exceed revenues). While the Greek government eeked out a small primary budget surplus (that is, revenues exceeded expenditures net of debt payments) in 2014, the further collapse of the Greek economy during the first half of 2015 has almost surely thrown them back into a deficit. What this means is that if Greece were to halt all debt service (again), and assuming no further credit would be forthcoming from either public or private sources, additional fiscal austerity would be required to restore a primary budget balance.

This is all very grim indeed. What is the best way forward? Making the best out of a very bad situation, should Greece stay in the euro area or recreate its own national currency?

In trying to assess the relative merits of staying or going, we see three key issues:

• Which option – in or out – is more likely to lead to the public debt reduction necessary to promote long-run growth?
• Which option – in or out – is more likely to lead to the structural reforms necessary to promote long-run growth?
• If Greece were to exit, does it have the institutional capacity to manage the introduction of a new currency and to engineer the real depreciation necessary to restore competitiveness?

On sovereign debt. In the long run, the Greek economy cannot grow without a large reduction in its public debt burden (see here for an earlier post on European debt). The IMF recently projected that the ratio of Greek sovereign debt will approach 200% of GDP within two years, assuming that it can obtain a needed €85 billion in new official finance by 2018. The prospect of sovereign default is not a new one for Greece. Reinhart and Rogoff observe that, in addition to its 2010 and 2012 debt restructurings, Greece has defaulted on its sovereign debt seven times since it became independent in 1829. (Cooley colorfully details several of these earlier episodes.)

In light of this history, it would seem easier to reduce the debt sharply by repudiating it first and negotiating later. But would it be easier to restructure the debt inside or outside of the euro area? The answer depends on how European policymakers behave.

German officials have argued that a debt write-down inside the euro area is incompatible with euro-area rules. However, EU officials have a history of legally-ratified flexibility in interpreting provisions of the Maastricht Treaty. Most recently, euro-area officials approved a re-profiling of Greek debt in 2012 that delayed and reduced Greece’s servicing burden. (Our friend and colleague, Luis Cabral, describes here – in Portuguese – a re-profiling of Portuguese sovereign debt between 2011 and 2013 equivalent to a haircut of five to ten percent.) In addition, the ECB’s quantitative easing program appears virtually indistinguishable from the “monetary finance” that the Treaty clearly proscribes. Indeed, the ECB has subsidized Greek banks (which own Greek sovereign debt) for years by accepting sub-investment-grade collateral in return for its large provision of credit.

On the other side of the ledger, if Greece were to default outside the euro area, it could still face retribution from the European Union (EU), not just the Eurogroup. In fact, there is no clear path under the EU’s Treaty of Lisbon for a country to exit the euro without exiting EU. Exiting the EU would be an economic disaster for Greece – beyond what has already been sustained – because it would undermine access to the country’s largest export market. Yet, the likelihood of exclusion from the EU seems very low.

Our conclusion is that, on balance, the needed debt reduction is probably easier to achieve if Greece were to leave.

On economic reforms. In the long run, the improvement of Greek living standards will depend on growth that results from efficiency improvements in how the economy operates.

How can we measure Greece’s progress on reforms that boost long-run growth prospects in a period when output has collapsed? The first chart below shows how the World Bank’s assessment of the ease of doing business has evolved since 2006, before the euro-area crisis began. The better Greece’s business environment, the higher its line in the figure. What stands out is how significantly Greece has advanced since its economic adjustment programs, and accompanying external supervision, began in 2010. (This is consistent with a recent OECD report that shows Greece as the member country most responsive to reform priorities over the 2007-14 period: see Figure 4.2 on page 108.)

However, Greece continues to lag all its euro-area companions with the exceptions of tiny Cyprus and Malta. Moreover, the 2015 “Doing Business” rankings were determined before the recent imposition of capital controls, the closing of Greek banks, and the spreading arrears in Greek government payments to its vendors. Consequently, a sharp deterioration in the 2016 round would be unsurprising.

Ease of Doing Business: Percentile Rankings by Country, 2006-15

Source: World Bank and authors' calculations.

So, is Greece more likely to implement badly needed structural reforms if it stays in the euro or if it leaves? It is impossible to know for certain, but the recent pattern supports the view that conditionality imposed by the official sector lenders fosters progress. This conclusion is reinforced by the Argentinian experience following the 2001 abandonment of its dollar peg and debt default: prospects for long-run reforms are limited in the absence of pressure from creditors.

However, reforms impose costs in the short run – costs that politicians are loathe to inflict, especially on publics as weary as the Greeks clearly are after shouldering increasingly heavy burdens over the past five years. In the end, economic reforms will only be sustainable in the presence of a strong democratic consensus, something that is hardly evident today.

On balance, reform is more likely to occur inside the euro area, but only just. In our view, the probability of substantial and sustained progress remains low whether Greece is in or out of the euro area.

Engineering a real depreciation. Many people have observed that it will be extremely difficult for Greece to introduce a new currency from scratch. In practice, such a momentous change would likely be gradual rather than abrupt. It would probably start with the Greek government issuing scrip to pay workers, pensioners, and vendors. Over time, this parallel currency could evolve into a full-fledged one. Even then, we expect that many payments would continue to be made in euros: in a world of capital controls, foreign vendors are unlikely to accept Greek currency risk, while Greece’s tourist industry (the country’s largest export) will welcome payments in euros. A shift to pricing in domestic currency would follow haltingly. As in countries that have experienced high and variable inflation, a stable currency (in this case, the euro) would remain in broad use.

Assuming that the formidable logistical challenges of introducing a new currency can be overcome, the key issue is whether Greek authorities will have sufficient credibility to engineer the real (or inflation adjusted) depreciation necessary to make Greece competitive. If, instead, holders of Greek scrip (or new drachma) lack confidence in the government’s (and central bank’s) willingness to limit the volume of the new currency, high inflation will prevent that real depreciation.

How big a problem are we talking about? How much would a new Greek currency’s value have to fall to make Greece competitive with other euro-area countries? Greece’s depression and mass unemployment have lowered its relative unit labor costs substantially since 2011 (see chart). However, compared to 2001, when Greece entered EMU, its competitiveness versus Germany has still deteriorated by more than 10%.

Competitiveness with Germany: Relative Unit Labor Costs, 1999-2014 (2001=100)

Source: European Commission (Excel file) and authors’ calculations.

Comparison with another recent instance of currency regime change leads us to conclude that a combination of debt reduction and a large real depreciation would offer Greece the greatest chance of restoring economic growth quickly. The case we have in mind is that of Argentina in 2001, when it defaulted, disbanded its currency board, and allowed the peso to depreciate sharply.

Like Greece, Argentina experienced a depression in the run-up to its December 2001 default and abandonment of the dollar peg: real GDP plunged by more than 15% from the spring of 1998 to the end of 2001. In the first quarter of 2002, output fell a further 5% (non-annualized), but that marked the trough. The subsequent expansion boosted the economy above Argentina’s pre-depression peak by early 2005. By the end of 2007, about six years from the default, output stood more than 25% above the 1998 peak.

In our view, one key to Argentina’s recovery was the whopping 57% decline of its real effective exchange rate in 2002 (see chart). While Argentine inflation rose sharply that year – officially to 23% – this was overwhelmed by the plunge of the peso, which sank from US$1.00 in 2001 to less than US$0.33 in 2002. Moreover, Argentine inflation settled back in subsequent years, helping to sustain the drop in the real exchange rate. Not surprisingly, Argentina’s improved competitiveness, combined with weak domestic demand, led to a plunge of imports (-53.6% in 2002) and a huge swing in net exports, from -1.2% of GDP in 2001 to +7.4% of GDP in 2002. Over time, the current account settled in at around +2% of GDP through 2009.

Argentina: Real GDP, consumer prices and the real effective exchange rate (percent change from year ago), 1999-2014

Sources: BIS, IMF and authors' calculations.

Can Greece engineer a large real depreciation to boost economic growth? Probably. There is little reason to believe that Argentina’s monetary and fiscal framework enjoyed greater credibility in 2002 than Greece would in 2015 if it exited the euro. Like Greece, Argentina had imposed capital controls. And, by converting deposits into pesos and limiting withdrawals, Argentina also imposed large losses on depositors.

Nevertheless, creating a credible monetary framework that avoids runaway inflation requires institutional capacity and credibility that is sure to be in short supply if Greece decides to leave the euro. And, given the proximity of Europe, capital controls may be less effective in Greece than they were in Argentina. It also remains to be seen how Greece’s business environment evolves after a euro exit. Will the reforms of recent years be sustained or reversed? Will the country still have full access to European markets? Will legal wrangles over debt restructuring forestall investment in Greece? Once again, the risks are substantial.

So, what’s our bottom line? Is Greece better off staying or going? Even if the choice is limited to a relatively narrow question about economic prospects, there is tremendous uncertainty. We suspect that a mix of economic reform and massive debt reduction inside the euro area – combined with new euro-area funds dedicated to recapitalizing Greek banks – would be the best option for both Greece and the euro area (and the global financial system). However, Greece’s creditors have not put such a deal on the table, possibly out of fear that other highly indebted countries (Italy?) will seek comparable terms.

Ultimately, if Greece lacks a democratic consensus to pursue additional economic reforms that would make it competitive inside the euro area, the economic incentives to default and let a new currency depreciate will become increasingly powerful. That still seems the most likely trajectory, even if there are better choices for both Greece and the euro area.