Greece

Now that Greek voters have voted “no” in the referendum, the government is engaged in a last-ditch effort to reach agreement with its creditors on policies and financing; if an agreement is not reached soon, a rapid move to a new currency appears likely. Among those who hope for or predict an agreement between Greece and its creditors that would keep it in the eurozone, there is a widely held belief that introduction of a new currency will be difficult, perhaps prohibitively so. Amid crisis and chaos, efforts by a discredited Greek government to reintroduce the drachma (or some new currency with a different name) would lead to further economic chaos, rapid depreciation, and hyperinflation, the story goes. Some have argued that a currency reform would fail, leaving Greece euroized like Montenegro—without an effective currency and operating on the euro but outside of the eurozone. In fact, the opposite is the case—introducing a new currency is the easy part; much harder is the task of building a social consensus—inside or outside of the euro—for sustainable and growth-promoting economic policies in Greece. Drachma or Euro: The Pressure to Decide Much of the discussion about whether Greece should remain in the euro has focused on whether it is truly a part of Europe’s optimal currency area, and whether there is a path for Greece within the eurozone where it can be competitive and grow. Even those who believe the answer is “yes”—including the IMF—acknowledge that the path for success is narrow. There is likely one last chance to reach agreement on a comprehensive agreement that combines significant policy reform with up-front debt reduction and adequate financial support. As of this writing, Greek banks remain closed and ATMs are about to run out of euros. This means that the formal payments system consists of electronic transfers between Greek citizens into accounts whose balances cannot be converted into cash. The economy, to the extent that it is operating, relies almost exclusively on barter. In this environment, Greece shows three characteristics common to many countries that have chosen to reform or change their currencies: (i) a government that was unable to finance essential services (i.e., a fiscal crisis); (ii) a government that sees politically unacceptable distributional consequences to remaining fully reliant on barter; and (iii) a government that has sufficient legal and political control to enforce the currency used in commerce within its borders. The government could begin to issue IOUs to address the fiscal issue, but not the distributional costs of the bank closures. There is a broad group of Greeks, including pensioners, who rely on cash from ATMs to survive. An IOU, unless it can be easily bartered for goods and services, will not address their concerns. In some cases—for example Argentina before it exited its currency board in 2002—a market for such IOUs developed that allowed cash to circulate within the economy. The deep discount on those IOUs then became a proxy for the value of the new currency that ultimately replaced them. Here, however, without a credible bank-based payments system, it is hard to see such a market surviving in Greece. In this environment, the pressure to change currency policy is substantial and immediate. The critical question from this perspective is not whether such a move meets the test of an optimal currency area. That question is usually answered with an assessment of whether the geographic and policy situation makes the currency an effective store of value, unit of account, and medium of exchange—the well-established purposes economists look to in assessing the efficiency of money. Rather, it’s whether the state has the authority to implement the move—that is, can it force citizens to accept the new currency within the country’s borders. And from this perspective, even amidst the chaos, the answer in Greece is a “yes”. This idea, that decisions on currency are ultimately driven by questions of state power, is what Charles Goodhart has called the “cartelist” theory of money. As Goodhart and others have pointed out, there is a strand running through cases as diverse as the Roman’s use of a cow (or “pecus”) standard for its currency, the U.S. confederacy’s rapid introduction of a new currency after the Civil War began, or the break-up of the former Soviet Union: the evolution of money is linked to the needs of the state to increase its power to command resources through monetization of its spending and taxing power. Currency Reform Lessons A successful currency reform requires a number of conditions be met over the medium term, including implementing legislation, issuance of new notes and coins, and measures to recapitalize and reopen the banking system. (Joe Gagnon has a very nice discussion of what is needed.) But there is a rich diversity of experience with the introduction of a new currency, which reminds us that this rarely happens by the book, particularly when the change is driven by an economic crisis. In the extreme, introduction of a new currency can be as easy as the government stamping the existing notes with a mark as a transitional measure until the new currency is designed and printed. Brazil’s transition from the cruzeiro to the real began by establishing “units of real value” as market-based units of account, and gradually adding other functions as the currency moved to have status as a legal tender. These moves were back by fiscal consolidation.  The Real Plan showed that a gradual transition can soften concerns about weak monetary institutions. Analysts also often point to the breakup of the former Soviet Union for examples of countries that moved to introduce their own currency only after detailed planning and preparation. But, of course, that was not always the case. In June 1992, months before the total collapse of the ruble-zone was a certainty, Estonia was the first of fourteen countries to break from the currency union. Over a long summer weekend, Estonia abandoned the monetary union and relaunched the kroon as the sole legal tender. The Bank of Estonia, which a year earlier had had only twenty-five employees, had neither the experience nor institutional capacity that the Bank of Greece has today; and tensions with Russia/CIS made it difficult to discuss settlement arrangements for a currency transition. As a result, the currency fluctuated wildly at first, though it eventually stabilized and provided support for the subsequent economic transition. Tight fiscal policy and structural reforms complemented the rigidity of the currency board, and eased Estonia into a market economy. There are costs to these types of transitions, notably in a reduced credibility of the new currency. A rapid introduction of a new currency raises the risk of counterfeiting, fraud, or abuse. But, in the end, it is overall macroeconomic and structural policies that are most important to determining the success of the new currency, rather than logistic or legal questions. Currency transitions must be accompanied by simultaneous structural reforms that enhance the credibility of the new currency and support the transformation of the economy. I have argued elsewhere that there is one last chance to get a deal that keeps Greece within the eurozone, and if that fails an exit makes most sense for Greece and for Europe.  But absent a better policy mix than has been seen so far, depreciation and default will not provide the basis for long-term growth. Today, achieving these structural reforms appears a hard task for any Greek government.

With around 60 percent of the vote counted in Greece, the No vote is 61 percent—a surprisingly wide victory for the Tsipras government. Fully 2/3 of young voters voted No.  What happens next? 1.  No major change in the deal on the table. Statements from European leaders in recent days showed a wide variety of views about whether a No vote in Greece would mark an irrevocable break with Europe. Outside Greece, it is easy to see this vote as a decisive call to exit Europe. Nonetheless, policymakers’ instinct is to leave the door to negotiations open, and it is my belief is that there is sufficient will on both sides to make one last effort to get a deal. But it will not come easily given the lack of trust between the parties and the still meaningful differences in policy measures that exist. Further, the policies that were voted on today have lapsed.  Any new package of policies and financing would need to be recreated and approved by all parliaments, which is a high hurdle. European leaders will need to coordinate their position first; tomorrow’s meeting between German Chancellor Angela Merkel and French President Francois Hollande is just a first step. Last week’s IMF report calling for debt relief in support of strong policies adds to the debate but shouldn’t be over read—in the near term I do not expect to see much change in the deal on the table. If the Greek government believes, as they say publicly, that a “No” vote will allow them to have their way, they will be badly disappointed, and such hopes are an impediment to any deal. 2.  All eyes on the European Central Bank. The ECB meets tomorrow to review a request from the Greek central bank to expand emergency assistance (ELA). Without an increase, the banks cannot reopen and the ATMs will be out of currency by Tuesday. By the letter of the law, the ECB should not increase liquidity to now-insolvent Greek banks. Indeed, they should increase the collateral required for the liquidity they have already provided.  But if there was a time for forbearance, this could be it. A decision to increase the ELA by a small amount—perhaps €3-5 billion—would be seen as an important good-faith gesture and would keep the ATMs working for a few more days, during which one last effort to negotiate could take place. Once the euros are gone, the pressure on the government will increase dramatically and a decision to create a new currency could be days away. 3.  Large external debt payments loom, but it’s domestic payments that could force the issue. Much of the focus is on €3.5 billion owed to European institutions on July 20 as a decisive moment. But without a deal in the works the Greek government may have difficulty rolling over domestic debt that comes due on July 10.  In the end, its the domestic dislocations that will determine the path forward.

There are reports this morning that the Greek government has made a new proposal (PDF) to break the deadlock, involving a two-year bailout program to be funded from European facilities (e.g., ESM) and with explicit debt relief, but without the IMF financial involvement. Eurozone finance ministers will review the proposal in a call tonight. Details are still limited, and I do not expect any agreement today (i.e., the IMF payment will be missed).  But a few initial thoughts. For this to be acceptable to creditors, the Greek government would need to accept the policy proposal tabled by creditors on Friday, with very minor modifications. This would represent an extraordinary U-turn by the Greek government, and breach all their previously stated red lines. Initial reports on the proposal do not mention policies, only the request for an extension of financing that on its own would be rejected.  I have no sense of the government’s motives, but it is possible that the significant distortions associated with the banks closing were a factor in the decision to make a new proposal. If agreement can be reached on policies and there is a commitment to renewed negotiations on financing/debt relief (the German government has said actual financing negotiations must come after the referendum), the government could then campaign for a yes vote in this weekend’s referendum, relieving pressure on the government to step down if the yes side wins. Agreement on policies would potentially allow the ECB to increase emergency liquidity under its ELA program, a necessary condition for banks to reopen.  This is a very narrow path to navigate. Because the previous bailout program expires tonight, entirely new financing arrangements would need to be devised. On the negative side, this is a much heavier lift because a new financial program would need fresh approval from parliaments already exhausted by the Greek saga. On the positive side, an underappreciated point is that by starting with a clean sheet of paper it gives parity to debt relief proposals that had been ruled out previously because they were not in the program.  I think both the IMF and U.S. government would support the greater emphasis on debt relief. Another last minute and chaotic scramble—not a great way to run policy.

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.

European finance ministers met earlier today and afterwards stated that new proposals from the Greek government were "broadly comprehensive" and "a solid basis" for restarting talks, but made clear that the Greek plan was far from complete and received too late for a deal to be concluded today. Markets had rallied earlier on hopes of a deal. But they fell back on comments from German Finance Minister Wolfgang Schauble and others who saw little new in the Greek proposal, suggesting significant splits among creditors. Leaders meet this evening, but it now appears that critical decisions will wait for the next finance ministers’ gathering, likely Thursday. Separately, the European Central Bank’s (ECB) board again expanded emergency assistance by 2 billion euros to Greek banks after weekend ATM withdrawals and orders for today reportedly exceeded 1.4 billion euros. With today’s modestly constructive statements though, it will be difficult for the ECB to cut off access to Greek banks over the next few days even in the face of broad insolvency in the Greek financial system. The new Greek proposal reportedly includes concessions on the value added tax (VAT) and a small move to limit the early retirement schemes that are a major contributor to the pension deficit. There appears to be broad consensus among creditors—if there is a deal—to provide financing to cover upcoming debt maturities, and they have signaled their willingness to commit to debt restructuring if Greece adheres to the program. But there appear to be many gaps in the Greek proposal, and a lot that can go wrong over the next few days. I would also expect pressure to mount on Prime Minister Alexis Tsipras back home.  Already, minority coalition partner ANEL said cutting the 30 percent VAT discount for the Greek islands, one of the most egregious examples of fiscal excess, would be reason to leave the government. It is also worth commenting on the dynamic between finance ministers and leaders. One recurring feature of the European crisis negotiations of the past several years is the desire of finance ministers to prevent their leaders from giving away too much to get last minute deals.  Consequently, even if the aim is to encourage negotiations, ministers will be wary to suggest a deal is close and will insist that negotiations remain with them. Negative comments from Finance Minister Schauble and others need to be interpreted in that light, and are likely to successfully dampen any hopes for a breakthrough at the leaders’ summit tonight. We will need to wait for more details on the Greek proposal.  If there is to be a deal, we know what it should look like to generate sustained Greek growth within the eurozone. But it is hard to be more optimistic this morning that the parties are closer to concluding such a deal.  The IMF in particular is likely to be quite disappointed with where negotiations seem to be headed. I share that concern, and fear that any deal being discussed is a "bridge to nowhere".  The risks of banking controls and default appear to remain high.