Eurozone

Bottom Line: If Greece exits the eurozone, introducing a new currency could occur quickly; getting the policies right is the more difficult challenge facing the country. Greece is engaged in last-ditch negotiations with creditors over policies, financing, and debt relief. Without a deal, Greece is headed down a path that could lead to its exit from the eurozone. There is a widely held belief that introducing a new currency will be difficult, perhaps prohibitively so. Amid crisis and chaos, efforts by a discredited Greek government to reintroduce the drachma would lead to further economic chaos, rapid depreciation, and hyperinflation. Some economists have even argued that a currency reform would fail, leaving Greece 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 will be the task of building a social consensus in Greece—inside or outside of the euro—for sustainable and growth-promoting economic policies. Euro or Drachma: The Pressure to Decide Much of the discussion about Greece remaining in the eurozone has focused on whether it is part of an optimal currency area with the rest of Europe.  This is part of a broader debate over whether Greece can be competitive and grow within the eurozone. Even those who believe the answer is yes, including the International Monetary Fund (IMF), acknowledge that the path for success is narrow. There is likely one last chance to reach a comprehensive agreement that combines significant policy reform with upfront debt reduction and adequate financial support. But financial conditions in Greece leave little time for negotiations. As of this writing, Greek banks remain closed and ATMs have run out of euros, which means the formal payments system consists of electronic transfers into blocked accounts. 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: a government unable to finance essential services (i.e., in fiscal crisis), sufficient legal and political control to enforce the currency used in commerce within its borders, and politically unacceptable distributional consequences to remaining fully reliant on barter. The government could begin to issue IOUs to address the fiscal issue, but not the distributional costs of the bank closure. 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, such as Argentina before its exit from its currency board in 2002, a market for these IOUs developed that allowed cash to circulate within the economy. The deep discount on those IOUs 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. 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. The real issue is whether the state has the authority to implement the move; that is, can it force citizens to accept the currency within its borders, to use it to pay taxes, or to accept it in return for services to the government. And from this perspective, even amid the chaos, the answer in Greece is yes. This idea, that decisions on currency are ultimately driven by questions of state power, is what economist Charles Goodhart calls the “cartalist” theory of money. As Goodhart and others have pointed out, there is a strand running through cases as diverse as ancient Rome’s use of a cow standard for its currency (the word pecuniary comes from pecus, the Latin word for cow), the U.S. confederacy’s rapid introduction of a new currency after the Civil War began, and the breakup of the former Soviet Union: the evolution of money is linked to the state’s need to increase its power and to command resources through monetization of its ability to spend and tax. Currency Reform Lessons A successful currency reform requires meeting a number of conditions over months or even years, including implementing legislation, issuance of new notes and coins, and measures to recapitalize and reopen the banking system. But the rich diversity of experiences regarding the introduction of a new currency affirms that this rarely happens by the book, and almost never when the change is driven by an economic crisis. At its most basic, the introduction of a new currency can be as easy as stamping the existing notes with a mark as a transitional measure until the new currency is developed. 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 legal tender. The Real Plan showed that a gradual transition can soften concerns about weak monetary institutions. Analysts 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 that was not always the case. In June 1992, months before the collapse of the ruble zone was certain, Estonia became the first of fourteen countries to break from the currency union. Over a weekend, Estonia abandoned the ruble and relaunched the kroon as the sole legal tender. The Bank of Estonia, which a year earlier had only twenty-five employees, had neither the experience nor institutional capacity that the Bank of Greece has; and tensions with Russia and the former Soviet republics 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, easing Estonia into a market economy. There are costs to these types of transitions, notably in reduced credibility for the new currency. A rapid introduction of a new currency raises the risk of counterfeiting, fraud, or abuse. But, in the end, macroeconomic and structural policies determine the success of a new currency, rather than logistical or legal questions. I have argued elsewhere that there is one last chance to reach a deal that keeps Greece in the eurozone, and if that fails an exit makes most sense for Greece and for Europe. But exit, depreciation, and default will not provide the basis for long-term growth absent structural reforms that enhance the credibility of the new currency and support the transformation of the economy. Today, achieving these structural reforms appears a hard task for any Greek government. Looking Ahead: Kahn's take on the news on the horizon More Than Stopgap Measures for Ukraine While Ukraine continues to negotiate with creditors over a debt restructuring, attention shifts to longer-term financing needs and the proper role for Western governments. Waiting for Normalization The Federal Reserve looks poised for an interest-rate liftoff later this year, but markets expect monetary policy to remain highly accommodative. Trade Advances Now that the U.S. Congress has passed trade promotion authority, there is pressure to conclude the Trans-Pacific Partnership agreement by the fall.

Bottom Line: If the past is any guide, the decisions now confronting the Greek government about who to pay and who not to—the politics of arrears—will present a critical challenge and likely define the future path of the crisis. As the Greek government scrambles to find a reform package that all parties can agree to, focus has turned to the government’s dwindling funds and mounting payment pressures. These include an April 9 payment to the International Monetary Fund (IMF) for $450 million and two treasury bills totaling 2.4 billion euros that Athens must roll over in mid-April, a challenge complicated by the significant holdings of external investors. But domestic payments are the more immediate and pressing challenge. In order to pay March wage and pension benefits, the government has been forced to tap the reserves of pension funds, state bodies, and utilities and delay payments to farmers, medical providers, and suppliers, among others. Going forward, Greek officials are reportedly considering the use of IOUs for the payment of salaries and pensions. Less politically sensitive payments to suppliers are likely to continue to lag, though pressure to make them will probably mount in coming weeks. In his letter to German Chancellor Angela Merkel last month, Greek Prime Minister Alexis Tsipras signaled that his government would not have sufficient resources without new assistance and would not make debt payments at the expense of social stability. How Did We Get Here? Tax revenue collapsed in the run up to the January 2015 election, and has contracted further in the uncertainty that has followed. In recent weeks, the Greek 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 gross domestic product (GDP) looks out of reach under current policies. Western creditor governments have made it clear that they are prepared to finance Greece, but need a willing partner to craft a coherent and sustainable economic plan. 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 past weeks (reportedly as much as 350 million to 400 million euros on some days), exacerbating liquidity problems. Lessons From Emerging Markets Running substantial arrears is a common feature of past emerging-market crises. The decision to pay some and not others involves allocative choices that are often new terrain for governments, and damage their capacity to operate efficiently. Suppliers and other providers of government services see arrears differing across sectors depending on the power of the relevant ministries and the revealed priorities of the government. IOUs might circulate but tend to trade at deep discounts given poor liquidity conditions. Capital controls can be necessary to stem flight, putting further strain on the economy. Fissures within governing coalitions can open up. This process is rarely structured or orderly. Figure 1: Greek Payments Due in the Second Quarter of 2015 Data Sources: Financial Times, Wall Street Journal   In such situations, it is not uncommon to see arrears exceeding 5 percent of GDP. (This was true in Greece in 2012.) In crisis that number could climb quickly. In the run-up to Russia’s 1998 crisis, wage and interfirm arrears paralleled a weakening of budget discipline and were reflective of what the IMF came to call a “culture of non-payment” that undermined support for continued adjustment and was an impediment to recovery. In Argentina, after the introduction of banking-sector controls in December 2001, arrears at the federal and local level mounted quickly. Paper IOUs issued by governments traded at deep discounts, and eventually most liabilities of the government and private sector were written down at preferred rates as part of an “asymmetric repesofication” by the government. A third example comes more recently from Venezuela, where the moral and political consequences of continuing to pay external debt at a time when the government was running comprehensive domestic arrears and rationing foreign currency generated a firestorm of debate. Getting out of arrears is a challenging task in the best of circumstances, though there are examples, including recently in Portugal, of governments implementing programs to resolve arrears as a central part of their crisis response. What Comes Next? The Greek government would like to tap EU bailout funds, but acknowledges that will take time. The government intends to introduce reforms this week that it hopes will unlock additional assistance, but all the signals are that these proposals are the start of what is likely to be a drawn-out negotiation. In the interim, it is looking for the European Central Bank (ECB) to provide financing—primarily though the Bank of Greece’s emergency liquidity assistance (ELA) mechanism, which now stands at around 70 billion euros—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. Taking the Right Message From Greece's Problems I am struck by how sanguine most analysts are about the crisis in Greece and its implications for the rest of Europe. Today, many experts 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 who 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. Any agreement reached will require approval by the Greek and foreign parliaments. Interim meetings can at best provide momentum to negotiations that justify ECB financing while these negotiations proceed. In the meantime, the future course of this crisis is likely to be altered by how Greece grapples with the politics of arrears. The perception that some groups have preferred access to scarce government resources—especially if decisions are made in a chaotic or nontransparent fashion—could strain the coalition and highlight the gap between campaign promises and reality. Ultimately, exit from the eurozone may be the only way to resolve these tensions and deal with accumulated insolvency. Conversely, strong governance in managing arrears, coupled with accelerated and realistic negotiations with its official creditors, can strengthen the government’s standing domestically and create the basis for an economy-wide consensus on adjustment within the eurozone. Although the outcome is by no means foreordained, the challenge of avoiding chaos eventually leading to Grexit is becoming more difficult by the day. Looking Ahead: Kahn's take on the news on the horizon Ukraine Struggles to Cut A Deal Ukraine’s negotiations with its private creditors are likely to prove difficult and an end- of-June deadline looms. The prospect of a debt moratorium has risen. More Rate Hike Delays Soft inflation data (and rising Greek risk) suggests the Federal Reserve can wait beyond June to begin hiking rates, but a 2015 liftoff still looks likely. Much-Needed Recovery for Europe European growth finally surprises on the upside, boosted by cheap oil and a weak euro, but voters may not feel a recovery.

Bottom Line: The European Central Bank's (ECB) recent asset-quality review (AQR) and stress test of eurozone banks was an important step. But restarting growth requires stronger macro policies if Europe is to avoid a Japan-style lost decade. That includes a more concerted effort to deal with the sovereign debt overhang that is a threat to consumption, investment, and growth. In my recent Policy Innovation Memorandum (PIM), I argue that the overhang of debt is a critical constraint on growth, and call for debt relief for Europe's periphery. Why now? Partly, I expect debt issues will return to the fore over the coming years as growth stalls, adjustment fatigue increases, and spreads on periphery sovereign debt rise again. In addition, many of the critical policy debates in Europe were sidelined while awaiting the ECB-led AQR and stress test of the major European banks, which was released at the end of October. Supporters hoped that a credible stress test, and the positive market reaction that resulted, would represent a turning point in the crisis and "jump-start" the European economy. "I definitely think the banking crisis is behind us," said Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem after the release of the report. Such optimism is misguided and dangerous. The AQR and stress test constitute a serious effort to address the capital shortfall and restore confidence in the financial system, but they do not address all concerns. The review sets the stage for the ECB to emerge as the single supervisor and regulator for Europe's major banks, an important—if incomplete—step toward banking union. This effort, however, will not jump-start lending or get Europe growing again. Without growth, how confident can we really be that the crisis is over? Absent more supportive policies, the banking sector cannot regain its health, capital will remain inadequate, and a year from now the stress test may well look unconvincing. In that regard, I agree with Gavyn Davies: the exercise is a "necessary, but far from sufficient, step to fix the low-growth, low-inflation condition that has become the norm in the European economy." Europe's Three Arrows: The Japanification of Europe Concerns about European growth are a growing weight on markets. At the recent International Monetary Fund (IMF) and World Bank annual meetings, there was widespread talk of the risk of "Japanification" of the European economy, meaning a prolonged period of underperforming growth and low inflation. Though there was no consensus, I came away convinced that Europe needs its own version of Japan's Abenomics—its own "three arrows": Monetary policy. ECB sources have been quoted as suggesting that bolder action, including the purchase of government bonds (quantitative easing, or QE), could come before the end of 2014 or at the January 2015 meeting. A narrow majority (Germany is not alone in its opposition) now seems to recognize that current policies are inadequate, but it appears unlikely that the ECB will be proactive or clearly articulate its commitment to QE unless growth and inflation numbers get significantly worse. Forward guidance on policy, as much as the purchases themselves, will provide the real boost in the European case. Fiscal policy. Europe needs a more countercyclical fiscal policy, with greater spending by the surplus countries providing the demand that is missing as the periphery countries continue to consolidate, but it is hard to imagine such coordination on fiscal policy any time soon. The IMF expects European fiscal policy to be broadly neutral in 2015–2016. Structural policies. Although Spain is credited with some significant reforms, the regional reform agenda—including labor-market, spending, and product-market reforms—lags elsewhere in Europe. A comprehensive supply-side reform is needed to raise potential growth, though it should be acknowledged that structural reform often is disruptive politically and economically in the short run. There are two problems here. First, these remedies are well understood by European leaders—the problem is not imagination, but leadership. Europe remains stuck, and it seems that only a crisis can spur the needed response. Second, the downside of the analogy to Japan and the three arrows of Abenomics is that Europe should also address a fourth arrow—the debt overhang—which exerts a continuing drag on investment and confidence. With the stress test complete, now is the time to address this problem as part of a comprehensive pro-growth package. Debt Policy: The Missing Fourth Arrow Across Europe, sovereign debt is higher than it was immediately following the financial crisis. Last year, gross government debt was 175 percent of gross domestic product (GDP) in Greece and 133 percent in Italy; Portugal and Ireland's governments both hold debt stocks over 120 percent of GDP. Meanwhile, household and corporate debt remains high and continues to threaten bank balance sheets. Low interest rates make these debt burdens manageable for now, and have allowed countries such as Greece and Portugal to reenter markets. But with growth through 2015 projected at an anemic 1 percent, this is a problem deferred, not solved. Continued uncertainty over debt will condemn Europe to years of low growth and its attendant ills. Growth projections for the short- and medium-term are far too low to relieve problems like extreme unemployment—in excess of 35 percent for youths in Spain, Greece, Portugal, and Italy—and the social and political instability it can ignite. Continued weak economic performance will only further reduce confidence and investment, possibly widening the premium on periphery sovereign debt. The way out of the growth doldrums resides in forcefully tackling the debt problem. Europe's leaders need to find the political will to launch a structured debt-relief program. In my PIM, I argue that one place to begin is by looking to the Paris Club, an informal group of official creditors that convenes to address debt problems in low- and middle-income countries. Though my European friends hate my analogy to a forum that supports developing countries, clear lessons can be drawn. Specifically, Europe should implement four of the Paris Club's principles. First, rules should be adopted on a case-by-case basis to tailor restructuring programs to a country's income and debt level. Second, predictable debt relief should be conditional on policy performance, including structural reforms, continued progress toward fiscal balance, and programs to address the burden of corporate-sector debt. Third, countries should receive a cutoff date that would delimit the debt eligible for restructuring. In all cases, only debt accrued before that date would be eligible. This makes the country receiving relief fully responsible for any future debt accumulated. Finally, comparability of treatment for other creditors should not be ruled out as needed. The Paris Club framework is particularly important in the case of Europe, where much of the debt is owed to creditors in the official sector. This is particularly true in the case of Greece. At the end of last year, Greece had received a total of nearly 215 billion euros from "the Troika"—a group made up of the European Commission, the ECB (through the European Financial Stability Facility, or EFSF), and the IMF. This amount was equivalent to 108 percent of Greece's 2013 GDP and 62 percent of its total debt stock (see Figure 1). As a result of the 2012 private restructuring, the vast majority of Greece's debt is now owed to official creditors. Resolving disputes among these official creditors will be much easier if a set of rules is in place. In addition, consideration could be given to reducing debt held by the European Central Bank as part of rescue efforts. Citigroup Chief Economist Willem Buiter has an innovative proposal to cancel ECB debt holdings purchased to fund a temporary fiscal stimulus package. The principle also applies to the bonds the ECB has acquired as part of rescue efforts in the periphery. Figure 1: Greece's Troika and Non-Troika Debt, Year-End 2013 Source: European Commission Criticisms of proposals like these often start with a call for realism. It is highly unlikely that Germany and the other creditor countries would agree to commit to debt relief, even if highly conditional on policy reform, because such a commitment would make explicit the costs of sustaining the European Monetary Union with an incomplete set of economic policies. These creditors are concerned by the precedent a major debt-relief effort might set and by the issue of moral hazard (i.e., that easy relief would encourage recipient countries to relax their reform efforts and return to their bad old ways). But making explicit the cost of saving the eurozone with all its current members is simply good governance, as compared to hiding the costs by presuming they will be repaid in full. Further, the moral hazard problem, though a real concern, can be addressed by making relief conditional on performance. Finally, over the longer term, Germany does not benefit from killing its export markets in the periphery. These factors together make a compelling case for a structured program of debt relief. A Lost Decade Now is the time to embark on a comprehensive effort to restart growth in Europe, including a fourth arrow aimed at debt reduction. Low interest rates, the relief provided by earlier maturity extensions, and the confidence that could be achieved from the stress test combine to create a window for action on the debt. A year from now, if growth has not returned, indebted governments will be called on to rescue or shore up weak banks, uncertainty will return, and confidence and investment will be much harder to achieve. Europe needs a rules-based approach to debt relief. The Paris Club is one place to look for guidance to begin setting these rules. The sooner they are established, the sooner Europe will see a return to growth. Otherwise, a lost decade looms. Looking Ahead: Kahn's take on the news on the horizon Lame Outlook for the Lame Duck The U.S. Congress faces a long to-do list for the lame-duck session but is likely to achieve little; the international agenda—e.g., IMF reform and trade promotion authority— is likely to be deferred. More Economic Woes for Ukraine and Russia In Ukraine, the IMF team heads out. A large financing gap looms, calling the IMF program into question. Meanwhile, the Russian economy slips into recession. A Global Slowdown October saw analysts marking down their global growth forecasts, a trend likely to continue in November.