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Elliott Morss | July 24, 2014

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Greece – Nothing Has Changed

© Elliott R. Morss

 July 2012

Introduction

 Last fall, I said that Greece and the other “weak sisters” should leave the Eurozone. My argument was: the weak sisters (Greece, Italy, Portugal, and Spain) cannot compete with Germany; they need currencies that devalue against the German currency to stay competitive. Since then, nothing important has changed:

The IMF plan to make Greece competitive with Germany has proven unworkable;

  • Greece has written off 70-75% of its private sector debt;
  • The European Central Bank (ECB) has purchased considerable Euro-bank debt;
  • The finances of other weak sisters, most notably Spain, have come under scrutiny; and
  • Germany has continued to insist that more austerity is the answer.

In what follows, I provide more detail on the Greek situation and the implications of its inevitable departure from the Eurozone. I also make the case on why the other weak sisters should leave.

The Current Situation

The following comes from a recent IMF report and various news articles:

  • Real GDP has declined by more than 13 percent since 2009; current and leading indicators suggest that domestic demand continues to contract sharply;
  • Competitiveness gains are not yet evident on an economy-wide basis;
  • The current account deficit has remained close to 10 percent of GDP despite the deeper recession;
  • The PSI deal triggered impairments of about €22 billion in bank capital, compared to system Tier 1 capital of €23.8 billion in September 2011. PSI wiped out the regulatory capital of four banks representing 44 percent of system assets, with other banks ending up significantly undercapitalized;
  • Greece must pay the ECB €3.1 billion next month or be in default;
  • Even with the PSI, Greek debt is projected to again reach an unsustainable 165% of GDP in 2013.

Austerity

Against this backdrop, it is worth examining the details of certain steps insisted on by Germany and other strong Euro countries. For example, German Finance Minister Wolfgang Schäuble said “If there have been delays, Greece must catch up.” Below, I consider where blind insistence on austerity will lead.

As part of the continuing austerity package, the IMF and European countries are insisting on reducing the government deficit from 9.3% of GDP in 2011 to 7.3% in 2012 to 4.6% in 2013. Table 1 demonstrates just how foolish and unrealistic this would prove to be.

Table 1. – Morss Austerity Calculations

Sources: IMF, Hellenic Statistical Authority and author’s calculations

First, according to the Hellenic Statistical Authority the average Greek salary in 2011 was €27,450 annually. We also know that the overall budget deficit of 9.3% in 2011 was €20 billion. From that, it is to calculate the expenditure cuts/tax increases resulting from lowering the deficit from 9.3% to 7.3% and then to 4.5%. These reductions, €4.3 billion and €5.8 billion in 2012 and 2013 constitute reductions in Greek aggregate demand. In the current circumstances, nothing will make this up, so these reductions will result in job losses. How many? The average Greek salary is €27,450. Dividing the GDP numbers by average salaries gives the job losses indicated in Table 1.

In short, the German insistence on austerity would cause the Greek unemployment rate to jump to 25.8% by the end of this year and to 33% in 2013. This is simply not going to happen. It would be political suicide for any Greek leaders to support such measures. So the Greek leaders have asked the Germans et al to stretch the deficit reductions over a few more years. But this will be costly: it would mean someone would have to finance Greek deficits for a longer time….

Deficits

We hear a lot about Greek deficits. What are we talking about? Table 2 is based on IMF estimates made in March 2012. There are three key Greek deficits – government, current account, and amortization. There are four sources of financing – European assistance, the IMF, defaults “gains” (PSI), and ECB support, mostly for banks.

Table 2. – Greece: Deficits and Finance

Source: IMF and author’s calculations

 Recognize that these estimates assume Greece will be able to reduce its government deficit to 7.3% of GDP this year and to 4.6% next year. The current account deficit reduction assumed by the IMF is also quite rosy.

So what might be done to cover the deficits? Greece can default on all further amortization payments. But beyond that? According to the IMF, Greece has about €5 billion in reserves left, mostly in gold. It can sell the gold and use the proceeds. When that is gone, Greece will be “out of money”. As long as Greece stays in the Eurozone, government expenditures will be limited to what the government takes in and the current account deficit will be limited to export proceeds.

The Problem – There Are No Policy Remedies

We hear that both the IMF and the European countries are unwilling to lend Greece more money. In large part, this is because they realize they do not have a viable policy to make Greece competitive while it remains in the Eurozone. Back in 2010, the IMF launched its reform program to bring Greece to “competitiveness via an “internal devaluation” (IMF words). That meant lowering prices and wages so Greek goods and services were competitive with those of Germany. It did not work.

So now the IMF and the European countries are floundering. Austerity has failed. The IMF program failed. Nobody knows what to do. They have given up on Greece and are worried about contagion.

Staying in the Eurozone

What happens to countries that are not “competitive” at the Euro exchange rate? They will not be able to sell their goods and services either domestically or abroad. The current account goes negative as imports grow and exports fall. In addition, unemployment goes up since nobody wants to buy the country’s production. In theory, these problems would be eliminated as wage rates and other production costs fall to a point where the country is again competitive. But mature nations have cost rigidities built in so things are not easily worked out – witness the IMF’s failed efforts in Greece.

The Alternative – Leaving the Eurozone, Devaluation and Loan Defaults

I have earlier covered in some detail how the weak sisters could leave the Eurozone. Some real disruption and havoc? Of course. But it is the only viable option: since all countries have downward cost rigidities, they need a currency that will devalue to keep them competitive in world markets. The IMF recently discussed the impact of a Greek departure from the Eurozone and its implications. I summarize their points below with some commentary.

IMF – exchange rate overvaluation could be promptly corrected via devaluation, while inflation/default would quickly address public debt problems.

Morss – If Greece adopted its own currency, the market would ultimately value it where Greece was competitive in selling and buying goods.

IMF – Balance sheet analysis suggests a rapid devaluation would severely impair the financial system, potentially triggering deposit outflows that could be contained only with controls.

Morss – In an earlier piece, I reported Fund estimated the Greece competitiveness gap of somewhere in the 11% – 33% range. This means Greek purchasing power under its own currency would fall by that amount. More deposit outflows? There have been large outflows. Are more possible? Sure.

IMF – Disorganization effects. The functioning of the payment system would be disrupted, and uncertainty would reign about contracts (with widespread litigation likely, aimed at testing any currency redenomination law). This could bring economic activity to a halt for some time.

Morss – Yup.

IMF – Financing constraints. The financial system, with its huge ECB exposure, would be badly damaged. Liquidity and credit would dry up, leaving companies to rely on internally generated funds. Under such a scenario GDP could contract by more than 10 percent in the first year, with a significantly larger decline in domestic demand. Greece’s large current account deficit would be swiftly unwound via import compression. Over time, depreciation would encourage a recovery in the tradable sector including manufacturing and tourism.

Elliott – Yes, but several points should be added. Greek business has been buying from and selling to foreign companies for many years. Foreign companies benefit from sales to Greece, just as Greek business benefits from sales abroad. Both sides want these transactions to continue, and they will at an exchange rate that better reflects Greece’s competitive position.

IMF – Market perceptions of the Euro area’s stability would suffer, and investors would attach increased probability to the possibility of additional Euro exits (which an effective firewall could mitigate, but could not eliminate). In addition, the use of blunt instruments to manage Euro exit, such as deposit freezes and capital controls, could spook depositors, and investors in other weak Euro area countries, triggering preemptive deposit runs and capital flight. Moreover, bank deleveraging, to reduce risks, could lead to self-fulfilling crises in vulnerable countries, with domino effects to others.

Elliott – Yes. Contagion risks will be high. But what is the alternative? Take Spain – is bailing out their banks and lending the government more money going to solve its problems with an unemployment rate of almost 50% among younger workers?

Investment Implications

If you are a gambler, short the Eurozone. If you are not, stay away. There will be a lot more panic and drama as this mess slowly unravels.

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