Economic Crises

This is how Grexit happens. Following the collapse of negotiations between Greece and its creditors, the European Central Bank (ECB) has halted emergency liquidity assistance. Facing an intensified bank run, the Greek government on Sunday introduced banking controls and declared a bank holiday. With substantial wage and benefit payments due this week and local banks out of cash, economic conditions are likely to deteriorate quickly in Greece ahead of a planned referendum for July 5 asking Greek voters whether the government should accept a creditor-backed reform plan. Creditor governments have left the door open for an agreement, one that if fully implemented and coupled with debt relief could be transformative for Greece. But that deal never seemed close and now seems out of reach. I am skeptical that economic or political conditions exist to allow a prolonged period of controls (e.g., Cyprus). Pressures to exit the euro and monetize government spending will become acute, and could outpace the sort of political transition or realignment within Greece that would allow a deal. Where are we? First, here’s a quick review of the weekend. On Friday, the Greek government surprised creditors by rejecting their compromise proposal and announcing their intent to hold a referendum on the plan on July 5 (with a “no” recommendation from the government). Markets had rallied on expectation of a deal, and even deal skeptics thought negotiations would continue up to and after the June 30 deadline for making payments to the International Monetary Fund (IMF). Eurozone finance ministers reacted sharply, announcing that negotiations had ended and that discussions had turned to “Plan B." This led several ministers (perhaps alluding to Greek Finance Minister Yanis Varoufakis’s frequent references to game theory) to suggest it was “game over." Late Saturday night, Parliament approved the referendum for next Sunday, July 5, and the proposal now goes to Greece’s president, Prokopis Pavlopoulos, for approval. Unless the vote is called off, and given the escalating rhetoric domestically against creditor governments, it is difficult to see the Greek government returning to the table before that vote. Given these developments, on Sunday the ECB suspended the provision of additional liquidity under its emergency lending facility (ELA). It is hard to fault the ECB: the additional liquidity provision (€9 billion in past week alone) had required forbearance under their rules, and had been justified by continuation of the negotiations. It is my understanding that should there be formal finding that Greek banks are insolvent, the ECB would need to end the program, but for now a freeze in access at current levels is a significant forcing event. Lastly, Greek Prime Minister Alexis Tsipras this evening announced the imposition of broad banking and capital controls. All banks--including branches of foreign banks--will remain closed for six business days, until after the referendum.  ATM withdrawals will be limited to €60 per day (foreign bank cards would be exempted, presumably as a concession to the tourism sector).  Wages can be paid online, but there will be tight controls on transfers abroad. This leaves unanswered the extent to which payments can be made electronically within the country.  The Athens stock exchange also will be closed for an indefinite period. What’s next: Four Points Banking controls and a banking holiday will cause a rapid deterioration in the Greek economy. Economic activity in Greece has already been badly damaged by arrears and a loss in confidence, and disintermediation of the banks has been reflected in greater reliance on cash-based transactions. Households reportedly have hoarded euros, but firms have been stretched by the crisis. Going forward, reduced expectations for a deal, concerns about currency redenomination, and limited availability of euros all work to trigger a cascade of business failures, rising numbers of non-performing loans, and further reduced tax compliance. Moreover, around 75 percent of Greek primary government spending is for pension, wages, and benefits, and large payments are due in coming days. Without an operating banking system, the dislocation from non-payment of these obligations will be substantial even without the panicked bank lines that formed Sunday night. External default will have a lesser effect in the near term. There is little doubt now that on Tuesday the Greek government will miss its €1.6 billion payment to the IMF, and the Fund’s board likely will move quickly to enact its normal procedures for arrears. I do expect European governments to show restraint and not call their loans in default based on the IMF move, but it will make any program in the future more difficult to negotiate and finance. A Cyprus-like extended period of capital controls and restructuring within the eurozone does not look economically or politically viable for long. In a situation of severe financial stress, the government will quickly have to decide whether to issue IOUs to cover its expenses. In this case, a de facto "dual currency" would start to circulate domestically. If there was a creditor-backed program in effect, and the ECB was providing liquidity (as for example, was the case in Cyprus), this situation could be sustained for a period of time while debt is restructured and banks recapitalized. IOUs would trade at a discount, but those in critical need of liquidity could find it. That will not be the case here, and further the existence of a primary deficit means that the government will be unable to finance high-priority social spending. There may be some useful lessons to be learned from the Argentina default, where dislocations were reduced by developing a secondary domestic payments system that allowed for transfers within the country between frozen accounts. Even in this case, the government paid a high political price for reneging on their commitment to protect depositors.  From this perspective, the focus should be on what happens in the week after the referendum, as cash balances are exhausted and when pressures to reopen the banks will be strong.  In this environment, the incentive to turn to the printing press will be substantial. Contagion will be less than in 2010, but we should still be worried. European policymakers are at least publicly sanguine that there will be limited contagion from this weekend’s developments. No doubt, we are in better position than 2008 and 2010, given European rescue facilities that have been put in place, other reforms (e.g. banking union) and the existence of the ECB’s quantitative easing program (QE). Further, there is limited bank exposure and most of the debt is owed to the official sector, limiting the risks from financial market interconnectedness. The Eurogroup and the European Central Bank have both signaled their intent to “make full use of all available instruments to preserve the integrity and stability of the euro area.” Taking a page from the U.S. crisis playbook of 2008, that indicates a willingness to bring overwhelming force in coming days. At a minimum, it suggests aggressive purchase of periphery sovereign debt (which is already allowed under the existing QE, though statements suggesting an extension of the policy may make sense), additional liquidity operations, and perhaps even the activation of swap lines. Still, I suspect markets have underpriced the risk of dislocations in coming days. In addition to poor positioning by investors that came back into risk assets on hopes of a deal and limited market liquidity, markets can now no longer avoid acknowledging that substantial loses will need to be borne on Greek assets. Questions may also be raised about debt sustainability in other periphery countries. Any sense of a loss of political resolve elsewhere in the periphery also will be a source of contagion. My expectation is that the rise in sovereign spreads will be modest, with the main contagion seen on assets the ECB does not buy under its QE program. That could include bank stocks and high yield bonds. The euro should see a significant depreciation against the dollar, reflecting expectations of extended monetary easing from the ECB with a safe-haven effect towards the United States. This safe-haven effect could be counterbalanced if markets believe the turmoil in Europe will delay the Fed’s plans for an interest rate increase. The referendum freezes negotiations, but neither a “yes” nor a “no” vote creates a clear path to a deal. Early polls suggest a small advantage for the yes position–that Greece should agree with creditors on a package—but local analysts caution against reading too much into these early reads. In particular, it may be much easier to campaign against austerity (with government support) than for tough reforms. Much will depend on the reaction to the bank controls, and opinion polls will drive markets in coming days. There is a broad consensus that a no vote on July 5 would strengthen the government’s resistance to a deal and make an eventual Grexit more likely. Even if the referendum passes on July 5, it is unclear that it would lead to rapid agreement on a new package. First, the government has rejected the terms on the table, so that trust that they would implement any agreement is low. Further, the financial package offered last week would have expired once the current program ends on June 30. Of course, creditors could offer those terms again, but that would require a new program and new parliamentary approvals, substantially raising the political impediments to a deal. In sum, time is short to avoid exit. The week after the referendum could be decisive.

It is time for banking controls in Greece. Delay at this point will only compound the chaos. Consider the following. Thursday’s meeting of Euro-area finance ministers made no progress toward a deal. That was not surprising. What was more noticeable was the discord that followed. IMF Managing Director Christine Lagarde summed it up: for a Greek deal to happen, there will have to be “adults in the room”. There will now be an emergency leader’s summit on Monday, but absent a major U-turn by the Greek government, that meeting is likely to turn to a discussion of “plan b.” Against this backdrop, there has been a rapid acceleration in outflows from the banking system, reportedly in excess of €2bn in the first three days of week. Deposit flight likely will intensify tomorrow and Monday. The ECB will hold an emergency phone call this morning to decide whether to expand emergency assistance (ELA) to the Greek banking system from its current limit of €81 billion. To keep the banks open, the ECB will need to provide a significant injection of liquidity. They should not do it. Greek banks are clearly insolvent. The crisis has caused a spike in non-performing loans, the economy is deteriorating rapidly, and with the Greek government on the verge of default to the IMF, the ECB can no longer pretend that the Greek government bonds that the banks have provided as collateral for past loans are adequate protection against loss. (Arrears to the IMF do not force other creditors’ claims into default, but the political statement of non-cooperation would be powerful unless serious negotiations are underway.) Further, ready access to central bank liquidity has disabled an important source of market discipline on the government, throws good money after bad, and creditor frustration with the continuing demands for financing make the politics of a deal all the more challenging. The Greek government is likely to resist imposing banking controls, but absent an agreement with creditors controls on deposit withdrawals and cross-border transfers look unavoidable once ECB liquidity support has been curtailed. Controls will buy some time for the government, but how much is unclear. The immediate challenge is fiscal and domestic. The government reported a sharp fall in fiscal revenue last month, reflecting a declining economy and substantial tax non-compliance. In response, it has slashed spending and delayed payments to suppliers and contractors. But large-scale arrears are causing significant payments difficulties in the broader economy, and are not sustainable for long when banks can’t lend. For this reason, I am skeptical that the government can sustain deficit spending for long through creation of IOUs, a informal secondary currency within Greece. How the government responds to these fiscal challenges will go a long way to determining whether controls are a way station to Grexit or, as elsewhere (e.g., Cyprus), breathing space to restructure and adjust within the currency union. My colleague Sebastian Mallaby has an excellent discussion of the perils for Greece of heading down this path, and he makes a convincing case that Grexit is not an easy option. The converse is also true. The international community has coalesced around the policies needed to put Greece on a sustainable path within the Eurozone. That includes additional debt relief and perhaps as much as 2 percentage points of GDP in new measures this year alone—including to pensions, wages, and taxes—measures that the Greek government has firmly rejected and that would be a major economic and political challenge to pass and implement. If Greece were to accept the deal, Europe would need to provide additional debt relief to make the numbers add up, a point recently emphasized by the IMF. Tough decisions are called for on both sides, and the prospect for bridging this gap is looking increasingly remote. While the temptation thus exists to buy time by extending the current program, trading cash for partial reforms, and putting off negotiations on a third bailout until the fall, it is a “bridge to nowhere” if it doesn’t put Greece on a credible path back to sustainable growth.            

Negotiations continue today between Greece and its creditors, with reports that the government has presented a revised proposal that offers minor concessions in an effort to break the deadlock. A deal is needed in the next week if a package of assistance is to be put in place before end-month payments of $1.7 billion are due to the IMF. While this is not a hard deadline—a short-term default to the IMF need not sink the Greek economy—the government is out of cash and it is hard to imagine how they make critical domestic payments without an injection of cash from creditors. At times like this, the focus is always on getting a deal done, but this negotiation, even if successful, is likely to defer hard choices for a few months in the hope that Greek domestic politics will change to allow a third bail-out program. The two sides are far apart, both in terms of the policies that need to be taken in the short term and the longer term vision for restoring growth. It is hard not to conclude this is a bridge to nowhere.  A few points. The two sides are farther apart than the headline numbers suggest. The revised Greek proposal offers a primary surplus of 0.75 percent this year, 1.75 percent in 2016 and 2.75 percent in 2017, compared to the creditor proposal of one, two and three percent, respectively. Seemingly small amounts and one could wrongly conclude the sides are close, but these numbers mask major differences in policy. With current policies, Greece will run a primary deficit this year of around 2/3 of a percent of GDP, and if the government moves ahead with proposed changes to labor and pension laws, the deficit could be substantially larger. Partly this deficit reflects the fall in activity, partly it reflects policy measures from the new government. Thus, even to hit the Greek targets require around 1½ percent of GDP in new measures this year, and substantial additional reforms in subsequent years. This is a lot to ask of a government built on a fragile coalition of interests and elected to do the opposite. Elections have consequences. The core policies in any deal are well known. Creditors have outlined a set of proposals that will need to form the basis for any deal. They reportedly include: (i) an increase in the VAT, currently one of the lowest in the EU, to raise collections by 1 percent of GDP; (ii) public sector wage cuts of 1 percent annually starting next year; (iii) pension cuts of around 1 percent of GDP by 2017 to put the pension system on a fully-paid basis; (iv) a redesigned social safety net system saving ½ percent of GDP per year; and (v) a labor consultation process that would put the brakes on the government’s efforts to roll back previous labor market reforms. There are also privatization proposals, but the program shouldn’t hinge on that element given the inherent uncertainty and lags involved. Creditors have signaled a willingness to negotiate the numbers, but it is hard to imagine a deal that doesn’t include these elements. The pension issue appears the most divisive, though creditors should be willing to accept a continuing pension deficit if the amounts are made up elsewhere. While pro-growth in the longer-term, these policies are a near-term drag on activity at a difficult time. To the frustration of Greece’s creditors, the government has failed on multiple occasions to come up with a coherent or well-developed set of proposals to achieve these savings. The revised Greek proposal reportedly focuses on the headline numbers and comprehensive debt relief, instead of the policies. I have long been supportive of substantial debt relief for Greece (and other overly indebted periphery countries), but I also believe that the creditor’s proposals are a reasonable price to ask in return. That is the grand bargain that should be the goal. But while both sides can be criticized, it is hard not to conclude that the government knows what policies are needed to clinch a deal, but that they are simply unwilling or unable at this point to agree to such policies. Perhaps there is a “Hastert rule” in play in Greece, and the government cannot politically go ahead with a program that does not command a majority of Syriza parliamentarians (opposition parties have signaled their willingness to support a deal). The bottom line here is that while the headline differences are small, the policy and political gulf is vast. The G7 closes ranks. At this weekend’s G7 meeting, there was a strong consensus that Greece needed to make tough and significant decisions to get a deal done.  The United States had in recent weeks been seen to be pressing European leaders to compromise, but President Obama’s statement showed little space between him and the other members of the G7:  "What it’s going to require is Greece being serious about making some important reforms not only to satisfy creditors, but, more importantly, to create a platform whereby the Greek economy can start growing again and prosper.  And so the Greeks are going to have to follow through and make some tough political choices that will be good for the long term." Domestic payments are still the trip wire. Even if most or all external debt payments were deferred or forgiven, Greece would still need additional resources in the near term while negotiations on a longer term program proceed. A bank run adds to the needs. The government proposes to meet the need through additional treasury bill issuance, which in the end would be financed by the ECB’s Emergency Liquidity Assistance (ELA). ELA exposure to Greece now stands at around €80 billion, and it is understandable that the ECB is wary of being the lender of first resort for an open-ended transitional period. But without this support, growing domestic arrears and missed payments will have a damaging effect on an already slowing economy and put further political pressure on the government. Banking controls inevitably would follow. In the end, non-payment to the IMF need not cause huge dislocations for the Greek economy. Not paying pensions or government wages in full would. The inflation tax is becoming more attractive. One often-cited advantage from leaving the eurozone is the growth boost that could come from the resultant depreciation, but that presumes that Greece could develop a vibrant non-tourist export sector with a more competitive exchange rate. That is hard to imagine being done easily given current policies. Perhaps a more powerful near-term argument for exit is simply that it relieves fiscal pressure by allowing the government to print money. The inflation tax that results is hugely distortive, but not necessarily more so than the current situation of widespread and growing domestic arrears. In the end, whether there is a deal or not is a political decision with substantial consequence for Greece and also for Europe. But beyond handicapping the deal, it is important to have a path for Greece that restores growth, and it’s hard to see how we are closer to that outcome now than before the most recent crisis.

Greece is running out of money. Greek Prime Minister Alexis Tsipras’s meeting this week with German Chancellor Angela Merkel has taken some of the toxicity out of the conversation for now, but cannot mask Greece’s current collision course with its creditors. Committed to a platform on which it was elected but that it cannot pay for, and with additional EU/ECB financing conditioned on reform, the Greek government is likely to run out of money in April (if not before). If past emerging market crises are any guide, the decisions that it will then confront about who to pay and who not to—the politics of arrears—will present a critical challenge to the government and likely define the future path of the crisis. Most analysts continue to argue that a deal that allows Greece to muddle through and avoid an exit from the eurozone (“Grexit”) is the most likely outcome. This argument is usually based on the assessment that there is a deal to be had, that Prime Minister Tsipras is a realistic leader that can over time navigate his coalition to a course that balances democratic accountability and a return to growth with the reforms needed to continue to receive assistance, and that both sides have too much to lose from a messy exit. All this may be true, but the political timeline over which this scenario plays out is measured in months, while the economic timeline is measured in days. The Greek government is now moving to prepare a more detailed set of reforms (including fiscal reform, privatization, social security and labor measures), based on the February 20 Eurogroup agreement, in hope of securing the approval in coming days from eurozone finance ministers. Any agreement reached will require approval by the Greek and foreign parliaments. Interim meetings can at best provide momentum to negotiations that justify short-term financing—most likely in small amounts and conditional on progress—while these negotiations proceed. That means that Greece will soon, perhaps as early as next week, begin to run arrears. How did we get here? Tax revenue collapsed in the run up to the election, and has contracted further in the uncertainty that has followed. Further, in recent weeks, the parliament has approved a number of anti-poverty measures and a payment plan for tax debtors, generating domestic support but taking policy further away from the previously approved program. It is unclear whether more controversial, but necessary reforms could win approval. As a result, even the reduced government primary surplus of 1.5 percent of GDP looks out of reach on current policies. This is not to criticize the government for seeking to keep its election promises, but rather to stress the large and growing gulf between its plans and what European creditors are willing to support. Unsurprisingly, bank deposits have begun to flow out of the system in the past week (reportedly as much as 350–400 million euros on some days), exacerbating liquidity problems. By some reports, Greece needs about 2 billion euros to meet its remaining obligations for March and more for April when it faces material debt payments, including to the IMF. Reports are that it will be able to cover the March pension and wage payments from its deposits and it can tap the reserves of pension funds, state bodies and utilities, but the outlook from then onward is unclear. Greek officials are reportedly considering the use of IOUs for the payment of salaries and pensions, and less politically sensitive payments to suppliers are also likely to lag. In his letter to Chancellor Merkel last week, Prime Minister Tsipras signaled that the government might not have sufficient resources for April and would not make debt payments at the expense of social stability. What comes next? The Greek government would like to tap EU bailout funds, but acknowledges that will take time. In the interim, they are looking for the ECB to provide financing—primarily though the Bank of Greece’s emergency liquidity assistance (ELA) mechanism which now stands around 70 billion—to illiquid Greek banks, which in turn can buy government paper. There should be no mistake that to do so would be pure fiscal financing. Consequently, it is not surprising that the ECB has opposed lifting the 3.5 billion euro cap on the amount of T-bills it will accept as collateral in exchange for central bank loans. What we have seen in emerging market crises in the past is that the running of arrears puts extraordinary pressure on a government, and this new Greek government is unlikely to be an exception. The decision to pay some and not others involves allocative choices that will be new terrain for the government. Suppliers and other providers of government services are likely to see arrears, differing across different sectors depending on the power of the relevant ministries and the revealed priorities of the government. IOUs might circulate but likely would trade at a deep discount given poor liquidity conditions.  Capital controls may be needed to stem flight, putting further strain on the economy. Fissures within the governing coalition could open up. This process is unlikely to be structured and orderly. In the end, should Greece survive the politics of arrears, they will still need a competitive economy and sustainable fiscal finances, and it is hard to see how the government’s current program gets them there. Sustainability can be achieved through Grexit (and the subsequent devaluation and debt restructuring), or it can be done though a rewriting of contracts to get relative prices right and reduce liabilities (“internal devaluation”) followed by an easing of controls. Either is possible, though the experience of Iceland and Cyprus remind us of the difficulty of getting rid of capital controls once they are in place. Either can produce a sustainable post-crisis Greece. That will be a big decision down the road, but for now Greece’s future is likely to be decided by the decisions made in coming weeks on who gets paid.  

The three major credit rating agencies have been accused of contributing to the global financial crisis, drawing increased oversight from regulators in the United States and Europe. Nonetheless, investors continue to rely on the largely unchanged ratings services.

The eurozone, once seen as a crowning achievement in the decades-long path toward European integration, continues to struggle with the effects of its sovereign debt crises and their implications for the future of the common currency.

During a seemingly successful trip to Asia last November, U.S. President Barack Obama announced several breakthroughs. Among them was a promise that the United States and Asian nations would proceed toward the Trans-Pacific Partnership (TPP) free trade deal. Obama and Chinese President Xi Jinping also announced a new climate deal, the first between the two powers, which will commit both the United States and China to significant emissions cuts over the next two decades. The TPP would seem to be just one of many indicators of our growing interconnectedness with Asia, and indeed of the interconnectedness of the entire world. Today, riots in Missouri are immediately broadcast on Al Jazeera in the Middle East; Facebook boasts hundreds of millions of users in India; and a plane crash in Indonesia is tweeted about around the world within minutes. But many deeper trends point in a different direction. Since the late 2000s, despite the superficial connectivity of Facebook and Twitter, the world has entered a period of what you might call deglobalization. Global trade growth has slowed dramatically from its normal pace. Banks’ investments and lending outside their borders has plummeted, and investors have pulled out of stock markets across the developing world. Cross-border migration is down. A comprehensive index of globalization produced by the Zurich-based research organization KOF Swiss Economic Institute, which includes such variables as investment dollars, tourism figures, and information flows over the Internet, finds that “globalization has stalled since the outbreak of the [international] financial crisis in 2008.” You can see more of my analysis on the continued power of deglobalization in the Boston Globe.