Last week, the price of Greek government debt soared on hopes of an 11th hour stick-save bailout by the European Union. Unfortunately, that price jump still left Greek bonds priced to reflect a default probability of 100% at every maturity. The jump only reflected an increase in the amount that bondholders evidently expect to recover in default, raising the implied recovery rate from the recent low near 30% to something closer to 50%. Put another way, the bond market has fully priced in the likelihood of a default coupled with a major haircut on Greek debt. What prices may not reflect is that the style of the haircut Greece wants may be modeled after former finance minister Yanis Varoufakis.
While a can-kicking bailout is still possible, it’s not at all clear that it would be desirable for anyone in the longer-run. Meanwhile, in my view, the blame and finger-pointing being aimed at Greece is not only unfortunate but unjust. In Antoine de Saint Exupery’s The Little Prince, the King of Asteroid 325 asks, “If I ordered a general to change himself into a sea bird, and the general did not obey me… which of us would be in the wrong?”
The fact is that the entire structure of the euro itself is wrong – flawed – because it demands exactly that sort of transformation by any country that is not sufficiently similar to stronger European countries such as Germany, France and Finland. One of the first things that international economists learn to appreciate is the idea of an “adjustment variable.” When two countries differ significantly in their growth, productivity, tax structure, demographics, and other factors, the relative differences are typically resolved by changes in exchange rates, interest rates, and price levels. Those adjustment variables provide a buffer for each country that allows them to adapt individually to economic differences and shocks.
The problem with the euro is that the treaty that allowed each country entry into the system was much like an errant request by the King of Asteroid 325: transform yourself into a sea bird. The prerequisite for a common currency is that countries share a wide range of common economic features. A single currency doesn’t just remove exchange rate flexibility. It also removes the ability to finance deficits through money creation, independent of other countries. Moreover, because capital flows often respond more to short-term interest rate differences (“carry trade” spreads) than to long-term credit conditions, the common currency of the euro has removed a great deal of interest rate variation between countries. It may seem like a good thing that countries like Greece, Spain, Italy, Portugal, and others have been able to borrow at interest rates close to those of Germany for nearly two decades. But that has also enabled them to run far larger and more persistent fiscal deficits than would have been possible if they had individually floating currencies.
The euro is essentially a monetary arrangement that encourages and enables wide differences in economic fundamentals between countries to be glossed over and kicked down the road through increasing indebtedness of the weaker countries in the union to the stronger members. This produces recurring crises when the debt burdens become so intolerable that even short-run refinancing can’t be achieved without bailouts.
Greece isn’t uniquely to blame. It’s unfortunately just the first country to arrive at that particular finish line. Greece is simply demonstrating that a common currency between economically disparate countries can’t be sustained without continuing subsidies from the more prosperous countries in the system to less prosperous ones.
Extreme debt burdens can be eliminated in only one of three ways: default, money creation, or austerity (budget cuts, pension reductions, wage cuts, and tax increases). Greek membership in the euro has made the first two options very difficult, and periodic bailouts only discourage more durable policy changes. Meanwhile, austerity policies and repeated episodes of crisis create nearly intolerable instability in the Greek economy. Constant demands for more austerity fuel animosity with other European countries, and discourage long-term planning and stable, productive investment.
In our view, it is in the best interests of Greece to have its own currency, so that interest rates, exchange rates, and if necessary, even domestic inflation can act as shock absorbers for its economy, rather than forcing human beings to become the only shock absorbers that Greece has left.
What is the greatest concern we should have about a Greek default, and a Greek exit from the euro? What is the greatest concern we should have if the global economy doesn’t continue down the road of financial distortion and stick-save bailouts at every turn? The answer is implicit in the question. The greatest concern is that we will have to face reality, and that we will have to adjust to reality in what will hopefully be a sustainable way instead of kicking that can down the road until no other options are available but large scale default, austerity, or inflation.
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