Analyst, James White, looks at the situation for Greece and the euro-zone and suggests that maybe, for Greece, the current crisis could have some positive outcomes.
Banished from the union
Voltaire’s phrase “Pour encourager les autres” or “to encourage the others” from his satirical novella Candide seems a particularly useful way of describing current attitudes towards a Greek exit from the euro-zone. The phrase referred to a fictionalised account of the execution of British Admiral John Byng. Byng was executed by the Royal Navy for failing to aggressively engage the French Navy at the Battle of Minorca with Voltaire implying that the execution stiffened the resolve of other admirals (there is strong evidence of this). In the case of the euro-zone, it seems jettisoning Greece from the currency union may serve as an encouragement for others to accept the necessary austerity measures.
A different view
Of course the market’s base case for a euro-zone exit is absolute disaster in Greece which will raise the probability of the establishment of euro-bonds and so, a potential solution for the euro-zone crisis. One analyst went as far as to say Greece could become the Somalia or Afghanistan of Europe. As is my wont, I will take a different view.
Greece outside the euro-zone
There are a number of points I would like to make.
As a preliminary however, I think there is a propensity within financial markets to think of financial markets as the be all and end all of society. While we’re important, it’s also the case that civil institutions can continue to exist and operate even in the absence of functioning financial markets. For the following analysis this condition, of course, will have to hold.
Long term problem
The euro-zone crisis remains a multi-year, if not decade long, problem. So it is possible that rather than encouraging the others to stay and accept austerity, there is time for a Greek recovery to emerge before austerity ends elsewhere. This increases the incentives of other peripherals to leave. As the following outlines, I think there is a strong probability of this happening.
The creation of a different currency in Greece may be a positive game-changer for its economy. A starting point for this analysis is thoughts about money. Keynes once described money as a theatre ticket:
The value of holding the money, not the money itself, is the value of the performance. Or alternatively, the value citizens infer from living in a particular country, and the value foreigners infer from conducting business in the country. On this basis there will be demand for Greek currency and so value (much depends on supply); the country won’t empty of people, and holiday-makers at some stage, will return. Similarly, the related demand for Greek property will support the new currency’s valuation.
So this sounds great in theory, but how will it work in practice?
A lot of the focus of analysis is on the devaluation of the new Greek currency – how far will it fall? This analysis, however, misses the other important element – volume. The money multiplier in Greece is currently close to negative. That is to say, if a Greek receives payments in euros, on a net basis, more than half of that will leave the economy. It’s stuffed into a mattress or lodged in a German bank account. As money exits the system, volumes of service activity, Greek to Greek commerce, can’t take place and a vicious circle of declining activity and more euro outflows is created. This whole process will reach a head when the Greek government can’t pay police and other emergency personnel, probably by July. Soon, if not already, barter will become an important means of exchange.
The value of a new currency
So once the Greek government starts spending the new currency, and so accepting it as payment for taxes, it gains some value and credibility. Devalued as it will be, it will allow the money multiplier to become positive and create more Greek to Greek commerce. This sets the scene for a return to growth, albeit from a weaker base, something that is currently unimaginable as cash continues to leave the Greek economy.
There is another benefit for Greece. By properly pricing Greece, the conditions required for a change in behaviour are created. So much is said about the fecklessness of the Greeks. But micro-economics and the free-loader principle make clear that this behaviour is only to be expected from a rational actor.
Behaving well or rationally
Currently, Greek interest rates are set artificially by the European Union with very limited access to funds. As a result, there’s no incentive to behave in the way Europe wants Greece to behave. There’s no upside to behaving well (accepting austerity in the form of job losses and higher taxes) for an individual household or firm. There is, however, an incentive to misbehave and get the best possible personal outcome. Some euro money will be there and an individual will try to maximise his or her share. Effectively, rather than being feckless, non-tax payers, Greeks are responding rationally to the behaviour of the EU ( rational behaviour is not a synonym of good behaviour).
But market set interest rates, as punitive as they will be (remember Indonesia faced ~60% in the Asia Crisis), will not fund bad behaviour and will reward good behaviour. By creating the right incentives, harsh as they will be, Greece will be forced to reform. Markets will impose a much more rigorous regime than the European Union. The government will spend a lot less and firms will become more efficient. Again the transformation of Indonesia, 10yr bonds trading at 4.92%, highlights how markets can change behaviour.
The exit of Greece from the euro-zone will bring untold financial disaster to Europe. I have no way of understanding the consequences. But for the Greeks, currently living in an economy that is quickly shrinking, where wealth has disappeared and economic activity just can’t occur, the new currency will bring substantial positives and may be enough to make it worthwhile. But a successful Greek exit, as judged a year or two from now, would be a disaster for the euro-zone. The head of Greece may not encourage the others in the way the euro-zone would want.
Who has the power?
Interestingly, this highlights just how strong Greece’s negotiating position is and how weak is that of the strong centre, Germany. Germany has two options to take back control. It can exit itself, jettisoning the weak but paying the financial and political price. Or, it can create euro-bonds, socialise the debts of all economies and take political control. But would the countries of Europe give up their political sovereignty?