Radical proposals for Greece (guest post by Justin Merrill)
The origins of the Eurozone crises were a balance of payments crises caused by ECB’s collateral policies and Basel regulations, and partly fueled by the ECB’s monetary policy. Banks could hoard higher yielding sovereign debt with zero risk weighting or fund property bubbles with mispriced risk. Additionally, the ECB’s collateral policies were pro-cyclical, allowing for liquidity to fuel capital flows before the crises, then restricting liquidity to the crises countries by applying larger haircuts or removing the assets from eligible collateral altogether. This explains the capital flows before the crises and why the credit spreads were so narrow. Critics use the pre-crises lending to Greece as an example of market irrationality, but I see it as proof of a rational response to regulatory arbitrage leading to systemic risk. As Kevin Dowd has recently explained, risk weightings, stress tests and other sorts of regulations cause systemic risk by crowding into the assets regulators approve of and incentivize.
I believe the solutions for the Eurozone’s problems are neither a fiscal union nor a banking union, but that’s a different post. The solution for Greece also is not more papering over with troika lending. They have a solvency problem that needs to be fixed with a combination of haircuts and supply side reforms, as well as a liquidity problem. Contrary to popular opinion, the Greeks are not lazy. According to the OECD, they work more hours per week than anyone else in the Eurozone with 2,042 average hours per year while the Germans work the least with 1,371 average hours per year. So obviously Greece has a productivity problem and needs to attract private investment, something I highly doubt a Grexit and capital controls will do.
My recommendations are a mix of idealism within political constraints. It isn’t my first best, but it would probably be achievable if Greece sought these policies because their implementation is not dependent on cooperation of other institutions.
A default by Greece does not necessitate a Grexit. If Illinois defaults on its pension liabilities in the future, will we be calling for their eviction from the union? If Puerto Rico defaults on its bonds will we demand they stop using dollars? Additionally, would it even be possible to prevent continued use of the Euro if the Greeks choose to continue doing so? I think returning to the Drachma would be the worst case scenario and I have thought of non-conventional solutions that don’t involve inflating away their liabilities or enforcing capital controls which would involve the destruction of their economy, the redenomination of private contracts, and a redistribution of resources towards the public sector from the private sector. My proposal will be restricted to money and banking reforms and what to do with the debt despite the fact that there are many needed supply side tax and regulatory reforms. This is because I believe the prime cause is monetary in nature. There are many countries with low productivity growth that don’t experience Greek like crises. BOP crisis can happen for many reasons, but the symptoms are similar. Currency depreciation isn’t a universal cure, especially when fear of future devaluation is one of the prime causes of BOP crisis.
A summary of my recommendation is that Greece should:
- Default on their debt
- Keep using the Euro
- Allow free banking
The capstone of my proposal is to allow free banking, especially assuming that for one reason or another Greece will be cut off from liquidity from the ECB. This means that Greek banks would issue their own notes (and possibly token small change) and deposits that would be redeemable at par for Euros, drastically reducing the banks’ dependence on the ECB for liquidity. Banks would still use Euros for reserves and, like a currency board, they would acquire reserves through net exports and capital inflows. Deposits in Greece may have to pay a risk premium over deposits in Germany, but that is no different than now. The premium may be lower than it is now once the threat of devaluation and capital controls is taken off the table. This alone would solve most of the problems caused by the currency union without leaving it. Of course Greece would still import the ECB’s monetary policy, but this is still far better than having an independent policy and all its political trappings.
Banks may initially need to put limits on ECB issued Euro withdrawals or external transfers, but this would be a voluntary agreement with depositors, sort of like how savings deposits can have withdrawal limits and payment can be deferred by up to two weeks as a contingency clause.
So this just leaves the question of what to do about that debt. The vast majority of Greece’s debt is now owned by the Troika. The good news is since it is no longer in the banking system the threat of contagion is off the table. The bad news is that a default may have harsh external political consequences. I say “screw ‘em” for three reasons. The first reason is that Greece will have a much more sustainable budget without paying interest or repaying principal. The second reason is that a total default would mean that Greece will be cut off from credit markets and will be forced to run a balanced budget for the foreseeable future. The third reason is that whoever was stupid enough to lend money to Greece should be burned for thinking Greece was capable of repaying. The best part of this is that a default by Greece would ruin the appetite for future bailouts!
Greece should either totally stick it to their creditors or convert their debt into a parallel domestic currency that is payable for taxes and banking reserves (I would do away with reserve requirements though). This way the creditors might get most of their principal back without any outlays from the Greek government. Domestic investors or speculators would buy them from the current creditors and use them to either pay taxes or buy Greek exports. The Greek government could then make part of their payroll and pension expenses in these irredeemable treasury notes. I would recommend that the supply of these be fixed at the current amount of debt outstanding, and not a new way to finance future spending. The supply may naturally dwindle over time as notes are destroyed or lost. I imagine they would have a high velocity since Gresham’s law would mean people would prefer to hold their Euros and private notes over the T-notes. Maybe the Greek government could offer to replace worn notes from banks to extend their circulation and increase their demand. It would be interesting to see if these trade at par or at a discount.
A friend responded to my proposal with skepticism because he didn’t see how the political climate in Greece would endorse the radically free market idea of free banking. I explained that given their alternatives, one doesn’t need to be a free market supporter to see the benefits to the Greeks. They could stumble their way into it similarly to how Somalia became stateless without being anarchists. But either way: default on the debt, stay on the Euro and free the Greek banks!