Plan A is the current official approach to Greece. It provides eur 110 bn in official loans for an initial 3-year period to sustain deficits which cannot be financed in the market. (The funds are charged at 3-month euribor +300 bps, rising to 400 if extended beyond three years.) Greece uses this breathing space to shrink those deficits and put the fiscal path on track to stabilise debt at an unspecified ratio of GDP; it peaks at 150% in 2013 and falls thereafter, crossing 120% in 2020. The government will also push through considerable structural reforms: privatize some SOEs; cut the minimum wage, weaken employment protections and collective bargaining power; and dismantle the barriers to entry/exit for the private sector. Finally, part of the overall loan package finances a stability fund to recapitalize domestic banks should they suffer a wave of asset failures. The ECB also provides unspecified liquidity support. (I am getting this from the IMF programme document (pdf).)

It’s hard to know where to start. Why not just cite the programme itself. Verbatim:

• overall debt service will rise sharply after the program: payments to both the Fund and EU would peak at 62 percent of exports of goods and service, and about 17 percent of GDP in 2015.
• Wage and price deflation, and contraction in activity could lead to sharp reductions in tax revenues, (upsetting the deficit trajectory).
• Fierce resistance from entrenched vested interests has stalled reforms in the past and the burden of adjustment will test the cohesiveness of Greek society. 
• Downwardly rigid private sector wages and prices given inflexible markets are a further risk, 
• as is the possibility of yet higher interest rates. 
• loss-making public enterprises could yet present additional pressures on the budget
• risks to banks are also acute until confidence in a strong downward path for the fiscal deficit takes firmer hold. 
• External risks include the possibility of negative spillover from other highly indebted countries in the region.

Plan B starts from the assumption that Plan A won’t work; that Greece will arrive at year 2013 still insolvent. The economy has contracted sharply so the external debt is even less sustainable. These adverse dynamics all the while send out destabilizing signals about the outlook for other indebted euro-members, creating a permanent euro-anxiety problem in the markets. Since markets prize certainty, Plan B gives it to them. Retained from Plan A are as much of the structural reforms as possible. To make these feasible, they take place in a growth environment. (Flexible labour markets in a contracting economy flexibly shed labour.) To make growth feasible, the drachma is re-introduced 1:1 with euro; its subsequent depreciation in the fx market ensures a positive external balance for the economy by reducing domestic costs. To ensure the latter, labour unions agree not to index wage demands to expectations of inflation, for some fixed period e.g. four years. This devaluation makes debt unpayable in euros; it is therefore decreed by force majeure to be payable in drachma. This is a unilateral default. Because the economy is generating an external surplus, it is not tapping external finance anyway. Such force majeure abrogations have been done many times; not least in the United States by FDR and Congress. The Greek public can hang on to euros if they wish, but they must pay taxes in drachma. Moreover, public sector pay will be in drachma.

It’s easy to find this revolting. But what are its virtues? Well, it crystallizes the problem now, not later, and frees the economy to begin growing again. Markets are no longer wondering what’s down the road. “What about the capital position of Greece’s external creditors?” you might ask. These banks will need a capital injection from official sources. Convert the EU loan package into exactly this recapitalisation fund. (Perhaps use the IMF credits to provide interim financing for Greece.) “Is this a breakup of the eurozone?” No. It’s a restructuring of the euro-zone. Each member has to assess the costs and benefits of membership at the present juncture. Greece is unlikely the only member to be best served by exit, but neither is it true that all members will exit. Moreover, this could be seen as an intermediate step toward a longer-term reunification of the EMU on much more solid fiscal foundations.

Plan C is really the alternative to Plan B, because Plan A is not an alternative at all. No democracy will put up with interminable austerity with little relief in sight. And it’s not clear that Greece’s concessionary creditors (German taxpayers) will be in the mood to continue providing exceptional financing after 2012 even though it is clear that this will be required. Germany (unwisely) has its own austerity law to comply with. OK, so what is the real alternative to Plan B? Let’s call Plan A “Fiction” because it’s no plan at all. Plan B is “Growth” because that is the emphasis. Plan C is “Shelter”. You end up with Plan C if the emphasis is on avoiding default. If the overriding goal is to make the creditors whole, then there is every reason to stay on the euro (why re-pay in a depreciated currency?). So Plan C keeps the euro. But since wages can’t be compressed enough to produce an internal devaluation adequate to generate an external surplus, and since that would anyway just blow out the debt/GDP ratio, and since there is no recourse to currency devaluation (vis a vis euro-zone neighbours), then the only choice is to devalue through trade and financial controls. Specifically: levy a special tax on imports and provide a special rebate to exports. Forbid all cross-border financial transactions except those cleared through a centralised external debt repayment agency.

As it happens, Plan C was pursued by many central European nations caught up in the Great Depression. They instituted exchange and trade controls to ensure that adequate foreign exchange was available for debt repayment. Naturally they kept the ex-ante pegged exchange rate, since this made the burden of repayment lighter than would a depreciated exchange rate. The point is that you had to get permission to transact. Far-fetched for a modern nation? Not really. Britain rationed foreign exchange for decades after the Second World War. In fact the very post-war international monetary system was designed explicitly with restrictions on foreign-exchange transactions, in order to help governments preserve their exchange-rate pegs. This collapsed not too long ago (late 1960s). And keep in mind that many modern-day economies ration foreign exchange for non-trade purposes; this is the definition of “capital controls”. Know too that inroads are already being made in that direction in Europe.

Europe’s choice is Growth or Shelter. Fiction is not a solution.

UPDATE

A point about Plan C. It isn’t really compatible with the freedom of citizens in any sustainable way. Since euros are rationed for cross-border transactions, one or more parallel currencies will materialise domestically, because the squeeze on domestic liquidity will be too fierce. Of course, the increasing emission of the parallel currency will drain euros out of the system, as we know from Gresham’s law. The only way to prevent this is for ever-more draconian steps to enforce the rationing of euros.

Great discussion between Martin Wolf and Stephen Roach over at Bloomberg.com. Is the US/China bilateral trade imbalance due to inadequate US savings or Chinese currency policy?

I’ve got a lot of time for both sides, which is frustrating. But here’s the thing: You can beat up on the USA for inadequate savings. But this is a bit like saying to an indebted shopper, Get your finances in order! But don’t stop shopping! What? I really think the capital account bears some responsibility for the over-indulgence of the borrower. Capital was pushed at the US economy by the decisions of others; namely, because of foreigners’ appetite for US financial assets. What is the flip side of a capital account surplus in a floating exchange-rate regime? Exactly my point. These things are accounting identities. The US laissez faire attitude to the external accounts leaves it at the mercy of others’ exchange-rate-regime policy. That might be fine 99% of the time, but when an exporter the size of China comes along, it’s going to make for an interesting story. And it sure has.

Over the last 12 months I’ve come round to the view that the US needs a pro-active approach to the dollar. That’s a huge shift in my thinking, because (a) I like the laissez-faire approach to exchange-rate determination, and (b) I don’t like beating up on China for being so successful as a saver and an exporter. (“Punish the creditor” initiatives often come up whenever reform of the international financial system is discussed. Predictably, they go nowhere. The Bretton Woods system itself was at one point meant to contain a provision to levy a fine against countries which run too-big or too-persistent external surpluses. This was aimed directly at the export leviathan of the time, the USA, and you can guess what Washington thought of it.) So if we can’t tell a sovereign nation what to do with its external monetary arrangements, then we’ve got to consider our own. Perhaps the mere idea of serious contemplation of this would be enough to spur changes abroad.

There is so much more on this topic. Stay tuned.

Worth checking out. Just a few quick things to add.

Wyplosz notes that if Greece leaves the euro, then its new currency will depreciate sharply against the euro, in which case:

The new GDP, measured in euros, will therefore decline to some €140 billion, 40% lower than initially. This works out to a public debt to GDP ratio of 210%. … Defaults by both the government and private borrowers would be unavoidable. At this stage, it is very difficult to see an exit from the euro area as a panacea. 

Huh? Nobody who recommends euro-exit is pretending that the debt burden will be sustainable. Come to think of it, nobody who recommends against euro-exit believes this either. So why cite the enormous debt/GDP burden as an argument? The point is that defaults are unavoidable in either path — the choice is whether we get there only after years of economic contraction, rising unemployment and general misery (with persistent fears plaguing the international capital markets), or we get there now, and let the Greek economy get back on its feet. Suffocation is no fun. I’ve said it before, but I sense a dogmatic quality to the arguments against euro-exit. “… it is very difficult to see an exit from the euro area as a panacea” means you’re not looking very hard. Try reading this insightful piece from the Economist for starters: “Default, and other dogmas“.

Next is Eichengreen. His statement, against euro-exit, is a parody of the argument, applied to the USA. Essentially, he asks, why aren’t we jumping up and down advocating Californian exit from the dollar? Well, California is not sovereign. Which is why the IMF doesn’t classify its currency arrangements. It does for each of the euro-zone members (their exchange-rate regimes are “no separate legal tender”). But California is a great example, because the emission of IOU’s by the state government is a pretty clear indication that California needs monetary relaxation.

When it comes to policy advice, be wary of Sachs. This is the man whose shock therapy did wonders for Russia. How apropos to the current debate. If I recall correctly, it was only when Russia kicked out Sachs, defaulted on its debt and devalued the currency that the economy turned around.

The FT’s Gillian Tett sounds a lot more sensible. From today’s FT:

But the alternative to restructuring will probably be grim too. If Greece staggers on, without a miracle, fears about future “haircuts” will continue to poison the bond markets and interbank world. That will essentially produce a pattern similar to Japan in the late 1990s: a world of gnawing, half-concealed anxiety, where asset prices keep stealthily slipping because investors cannot shrug off their fears of more bad news to come. 

1931. Till this point there had been no major sovereign debt default. That was about to change. Souring loans among the commodity exporters killed the appetite for foreign lending, and this “transformed the Central European financial situation” (p.261). The banking system there had grown heavily dependent upon foreign funds. As those vanished, there was little left to provide domestic depositors who wanted out. In May 1931, a lot of them did: the financial status of Austria’s biggest bank was revealed: “deteriorating loan performance had completely wiped out” its capital, in a bank whose balance sheet was as large as the government’s total budget (p. 265). The ensuing bank crisis was enough to bring down the Austrian currency and turn the spotlight on troubles in Hungary and Germany, bringing down their currencies too.

“Unaffordable” contracts between the state and its civil service seem like a coming step in the ‘great deleveraging’. Not just in Greece:

Having pared the budget to the bone, the city of Stockton, CA has resolved that it can no longer avoid revising the labour contracts of city employees.  Here’s the agenda (pdf) for the city council special meeting — look under “NEW BUSINESS” at the bottom:

And here’s the May 27 press release:

City of Stockton News Release

One reason for being optimistic about the fate of the euro is that leaving the monetary union would be a dramatically disastrous event for every one. Barry Eichengreen has written the definitive description of what that would entail.  Greece, if it were to leave, would see its new currency sharply depreciate, which could double up in local currency terms its already suffocating public debt and bankrupt millions of Greek private debtors, households and corporations alike. 

–Charles Wyplosz, Letter Opposing the Motion, “This house believes the euro area will fragment over the next ten years”. The Economist on-line. 


I beg to differ. This is very difficult because I’m citing monetary union during the Great Depression as an object lesson, and Eichengreen wrote the book on that dimension of the Depression. Nevertheless I have to speak out. This language — “leaving the monetary union would be a dramatically disastrous event for every one” — is conjectural. That it is stated so unequivocally reminds me of the dogmatic defence of the gold standard. Have a look. 

In polite conversation one often tends to moderate one’s view, in deference to the “golden mean” — the notion that the truth in any debate must lie between the two extremes. This is clearly not always appropriate. In a debate over astrology, for example, there’s no point taking a middle road. Indeed this would be dangerous, if it encourages people toward seeking solutions from falsehood. The danger is greater still when it’s the editorial staff of a major news organisation who follow the golden mean, reporting semi-sympathetically the objections of a physician to the MMR vaccine (BBC) or the murderous scare-mongering of chicken hawks (NYT).

The fate of EMU is a policy variable. I’ve been circumscribing my comments about this, both here and in other fora, to keep the focus on Greece and to keep the attention of sceptics. It’s time to be categorical. There is a path to an EMU that works for its members and its neighbours, but this (call it Plan A) is not it. The private and public debt of Greece, Spain and Portugal to external creditors is estimated at 2 trillion euros (FT citing RBS). Outright default would land these creditors in serious difficulty, and the EU leadership are right to have moved quickly to forestall this. But full repayment is out of the question. That’s why it is gratifying that the likes of George Magnus openly call for a friendly restructuring. This is part of the right path, call it Plan B. Like Plan A, it also includes structural reforms. Unlike Plan A, it calls for the re-introduction of national currencies in one or more of these countries, so that structural reforms can occur in a growth environment. After a further time period, and at the urging of the pubic rather than the elite, monetary reunification will be possible, on much firmer foundations. This will include an EU Treasury to float the first 60% of members’ outstanding debt, with the residual financed by members themselves; and centralized budgeting.

Where does Plan A lead? There are no official estimates of the wage cuts needed to push the euro-debtor economies into external surplus (equilibrium is not enough; they need to shift into surplus because there will be no financing other than self-financing; it is akin to retained earnings for a firm when it cannot access finance).  Krugman has put the wage cut necessary in Greece at 20%, relative to Germany. The IMF programme calls for wage cuts to be explicit in the public sector, but not the private sector (it is to take its cue from the public sector). The 750 billion euro “rescue” package keeps the creditors at bay for two years, but the creditors are still made whole. It’s the perfect anti-growth strategy, and the markets know it. It’s a bit like saying to the emergency room patient,

Here’s a blanket. We are going to suffocate you. We’ll be back in two years’ time. By then you had better have mutated into a butterfly. Because your debt/GDP ratio will be 150% (IMF). Come to think of it, your debt will still be 120% of GDP at the end of the decade. Assuming everything goes to plan. 

Globally, it’s time to take an extremely broad and realistic view. The credit boom from which we are all contracting was epic. We’ve made some valiant efforts to offset the beginning of the de-leveraging — fiscal stimuli in US, China, Germany, UK and elsewhere; policy rates at zero or near-zero; and expanded central bank balance sheets. But the will has flagged and the ‘hard money’ crowd are in the ascendant. Hell, they’re in power in the UK and Germany, and making inroads in the USA. The implication of the rectitude and austerity prescribed by this crowd is contraction.

There is an alternative. Start in Europe. Get a debt solution over with. It won’t be pretty but it won’t be nearly as bad as the hard money people will have you believe. AS SOON AS the overhang of debt is addressed in a realistic way, and a way which explicitly countenances a realistic growth path for the debtors, the markets will start discounting high growth. Because this is a bullish platform. Take the hyperinflationistas with a pinch of salt: paper money is not going to go up in flames. There is over-ample supply capacity in the global economy, and the worth of money comes not from the intrinsic value of the medium but the technology it serves: money is a means-of-exchange and has tremendous transactions utility. That’s why paper money has value. Come to mention it, this is the only way to explain why gold coins circulated at far in excess of their intrinsic metallic value in the 19th century. They fulfilled a transactions utility. You could have as easily looked at the gold standard back then and cried “fiat money!” as you can now. Not quite … but that’s a pandora’s box for later.

The following is from Q&A on “EMU as reprise of the gold standard”:

1. Convert the eur 750 bn rescue fund to a re-capitalisation fund for the banking system.
2. Force a restructuring of Greek sovereign debt; 70% write-down.
3. With an EU imprimatur, forcibly redenominate Greek contracts in drachma, including cross-border contracts.
4. Greek central bank exchanges euro for drachma at the rate of 1 for 1. There is no need to make it 1 to 5 or whatever. The point is that the drachma will depreciate against the euro and other currencies in the fx market, whilst still being used like a euro at home.
5. Gain the agreement of Greek unions not to index wage demands to expectations of inflation for a fixed time period of four years.

From people close to Greece and Spain in particular the sentiment is strongly expressed that the crisis today presents an “enormous opportunity” finally to push through reforms which have been long promised but undelivered, because of the usual near-term pain and opposition. We are talking about ‘structural reforms’, with labour-market reform at the top. An expert on Greece (and in Greece) is breathless at the possibilities. I want to add a caveat. These reforms need to happen in a growing economy. Otherwise a ‘flexible’ labour market flexibly sheds labour.

Where is growth to come from? The EU’s answer is ‘nowhere’. Have a look at the IMF programme (pdf) and judge for yourself. Yes, it projects real growth beginning in 2012 (1.1%). The point is to examine the logic of where this growth is supposed to come from. No less than 11% of GDP will be clipped from government expenditure (net, cumulative) in 2010-2013. Debt/GDP is forecast to reach 150% in 2013, and 120% in 2020.

There is another way.

What would you do if your nest eggs are in a mix of stocks (30%), bonds (65%) and cash (5%)? I still haven’t recovered from the 1996 recession.”

Questions like this are beyond me. But they are useful as a way to force a viewpoint on the likely outcomes here. The first thing to do is not to listen to me. I thought my friend was crazy for diverting her extra income to the stock market in March 2009; she actually timed the market perfectly.

Start from first principles. The official community is behind the current course pretty solidly, despite the market’s profound doubts. The messenger will be shot, not heard. So we have to go with the market’s verdict: it is pricing in negative GDP growth in the euro periphery. That will not be costless for the wider EU, hence the sell-off in the euro. Note: EU leaders are mistaken if they interpret this selloff as a bet against the euro as a currency. It isn’t. Just look at German bunds. Their yields are near an all-time low, and the yield incorporates the market’s viewpoint over currency risk. (Translation: the price of German debt is high because the market believes in the safety of this debt, which coincidentally will be repaid in euros, suggesting that the market is not overly concerned about the euro from an existential viewpoint.)

It will also not be costless for Club Med’s (and Ireland’s) non-euro neighbours. Little wonder the Turkish lira fell 7% in two days earlier this month and has resumed its slide after an intervention. The British pound’s decline is all to do with the trade consequences of the programmed Club Med/Ireland coma. The British government is responding to a phantom if it thinks sterling weakness reflects market disapproval of the fiscal profile. Of course, we’ve been here before, and the details are developed ad nauseum in this blog. It goes back to the Great Depression. One of the Depression’s great ironies (tragedies) was the widespread fear of inflation when deflation was the clear and present danger (h/t Eichengreen 1992). So we shouldn’t be surprised that Paul Krugman is a minority voice in explaining the deflationary dangers at hand today.

But this post is about the positive, not the normative. European currencies are going down. Add to this a whiff of fear in the capital markets, and you get (another) rush for the dollar. Folks like Peter Schiff might liken this to running towards the fire when the alarm goes off, but there are solid reasons for it. The dollar is the global numeraire. You can use it anywhere. In an emergency, you want to be in it. And the greater the emergency, the more liquid form of it the better. Taken to extremes, this means literal cash. It’s the only form of “central bank money” you have access to. (Bank reserves at the Fed are also central bank money, but they’re off-limits to you.) The rest is deposit money and other, higher, forms of money.

So we are going to have a stronger dollar. This feels like “the big postponement” of what we were all really hoping to witness: a shift of US growth into the traded sector. That’s what the whole ‘rebalancing’ thing is about. The US is on the road now to even greater indebtedness to China and other foreign creditors. Let me pause: I am a sino-phile. So whatever you construe from this post (or this blog) one thing it ain’t is China-bashing. But the statement stands: China (and others) are set to accrue more US liabilities. To my way of thinking, this only amplifies the eventual adjustment.

Setting aside my own views, I think I am safe to say that many fear this adjustment will be too big for market processes (and political systems, democratic or otherwise) to handle. We don’t have any good precedents for the upcoming handover in global leadership between the United States and China. The closest historical parallel, at least in modern times, is the baton-pass between Britain and the USA. One approach to the Great Depression blames the interwar travails on the vacuum in leadership created in the middle of that transition.

Britain and the USA shared an affinity of language, culture, etc. This seems less in evidence between the USA and China. There’s a larger point. One can argue that the rise of the United States economy at the turn of the 20th century was intensely destabilising for the global economy. The US was like a clumsy giant, unaware of its global impact and still unresolved over how to manage its own monetary system. China will eventually go through financial crises of its own, indeed it already has, and handled them well. There are reasons to be sanguine. I’ll go through those in a future post about USA/China, as well as my ‘normative’ policy programme. There is no point in fatalism.