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A Necessary Greek Devaluation and Default

Finance Blogger: Mindful Money Mindful Money

Yesterday was a day of great shame for Greece. However I wish to distinguish myself from the rolling 24 hours news coverage of the protest and the separate riot and firebombing. For me the great shame was Greece’s Parliament approving a set of austerity measures that no-one who has observed the Greek crisis so far can have any belief will actually happen. Even worse is the plain fact that whatever elements of the austerity package are implemented will only deepen Greece’s economic depression as I explained only last Monday.

Indeed some senior Greek politician’s are saying this openly. Here is Antonio Samaras the leader of the New Democracy party:

"The measures should be renegotiated after national elections expected in April."

So there you have it he does not expect the measures to last.

Even worse we had the technocratic Prime Minister of Greece who replaced an elected leader talking of Greek “democracy” when he is involved in no such thing. At least 74 deputies mustered their courage and voted no.

How would a default start?


The opening move in this situation would be for the Greek government to declare that in future its currency would be the New Drachma and that it going forward would be legal tender rather than the Euro. There are difficulties here in terms of having bank notes printed and the pricing structure of the Greek economy which would have to change very quickly and in some cases overnight.

What would be the new exchange-rate?


There are two main factors at play here. The first is that Greece needs to choose a level which makes her much more economically competitive. The second is that it looks credible with financial markets as she wishes to avoid volatility and extra turmoil if she can. These two issues do of course overlap to some extent. If we look at the situation there is bound to be some turmoil and volatility but a well-constructed plan will keep it to a minimum.

No doubt you are wondering how much? The European Central Bank calculates a competitiveness indicator which shows Greece to now be at 106.5 versus an index calculated at 100 when the Euro began. If we look at the successful German economy we see a competitiveness indicator at 82.3 so my suggestion would be for Greece to announce an opening exchange rate for the New Drachma some 25% lower than the previous Euro exchange rate.

If we look at the likely effect of such a move it may well be stronger than many would have you believe. If we look at Greece’s latest set of trade figures for December 2011 we see that 59% of her imports and 48% of her exports were with the European Union. So a large proportion of her trade would see an immediate economic benefit as she would be 25% more competitive with her Southern Mediterranean eurozone peers overnight which should give quite a boost. I do realise that the figures above are for the European Union and not the eurozone but lets us break that down. The gain for trade with eurozone countries is clear but my contention is that if the UK pound sterling is any guide then EU currencies will mostly move with the Euro on this.

Looking further afield then we have an interesting concept to face because “uncompetitive” Greece actually exports 52% of its products outside the European Union according to its figures. There is a little ray of light there is there not? A more price competitive Greece could over time perhaps do a fair bit better than this. So there is some hope for an improvement from an area which contradicts somewhat the stereotypes which have circulated.

This is not a panacea

The terms of trade will move against Greece


The initial effect of the move will be to make Greece’s position appear even worse. This is because at day one Greece’s exports will earn less per unit and her imports will cost more per unit because of the 25% devaluation. Whilst financial markets can adjust virtually instantaneously the real economy will take time. So there will be a period where the numbers look worse as the underlying real economy begins to make adjustments to the new more competitive situation. This is the logic which underlies what is called the J-curve in economics.

Inflation will rise


There will be an inflationary impact from the devaluation as Greece will have to get some products from abroad and their prices will rise in New Drachma. Obvious candidates are raw materials and oil as well as other imported goods. But it is a sign of the scale of the crisis facing Greece that I feel she needs to take this risk. I am also aware that the risk is bigger than the devaluation as a 25% devaluation means that the prices will be 33% higher in the New Drachma era.

Those holding bank deposits in Greece will lose out


Another casualty of this process is that savings and bank deposits in Greece (those that are left…) will be reduced by 25%. Those who hold physical Euro notes will probably be okay even the ones with the “Greek” stamp on them. I do not know this but I suspect that the trouble of wiping them out would be more than it is worth for the European Central Bank. In my view it is probably bright enough to figure out that if it did not accept Greek euro notes there would be a flight from the Euro notes of other countries in danger such as Portugal and maybe Spain. It does not want that…

What else does Greece need to do?


As hopefully this will be a once in a lifetime moment for Greece I believe that the package needs two other features.

1. A real push for supply-side economic reforms. Whilst there has been plenty of talk about this under the various plans under the auspices of the Troika (EU/ECB/IMF) there has been much less action. Even the IMF now admits this (it has not told the truth up until now) in its latest survey on Greece.

Structural reforms have not yet delivered expected results, in part because agreed reforms are not being implemented. For instance, two flagship reforms—on collective bargaining and liberalizing restricted professions—have yet to deliver substantial results.

If Greece is to succeed she needs to find a government and the national will to make the necessary changes here.

2. Greece needs to collect her taxes. One of the issues of the Greek crisis has been the fact that her position would have been a lot better if she merely collected her taxes. After nearly five years of supposed reform she looks as if very little progress has been made.

Accordingly in the new era this would need to change. One possible route would be to tax assets rather than income in some form with perhaps an extension of property taxes, although it we do not know how much income tax would be collected if a more efficient motivated body tried to do it.

The default itself


I have deliberately left this part to the end as I feel that for too long the interests of the creditors and banks have been emphasised at the expense of the Greeks. Actually I feel that the danger of this would be that they end up with nothing as the dangers of a revolution in Greece and a complete default on everything are growing as time progresses.

As in my new system all debts would be in New Drachma I have already provided a 25% haircut on any foreign debt holdings in Greece and this would apply not only to her national debt but to many private debts too. There are issues here as no doubt there will be legal disputes and litigation but I wish to point that out and move on.

However in debt terms for Greece this merely restores a status quo where she has much too large a national debt burden for even a new (hopefully) improving economy. Accordingly I suggest an additional 40% reduction in her public debt to reduce her new national debt ratio to economic output from around 160% to just under 100%. Foreign creditors will be hit hard but there is no other realistic way.

There will be serious damage to Greece’s banks which the Bank of Greece will need to address and it is my view that it should protect retail depositors but not give the same protection to the banks. This would be a reversal of current policy but I think that making an example of one bank would do some good and establish a new better tone. There will also be damage to Greek pension funds which I regret but cannot figure out a way to avoid. In a way this shows the seriousness of the situation.

Comment


Because of the seriousness of Greece’s situation the problems with a devaluation and default strategy have been outweighed for some time by the way that the current troika austerity programme is failing. Last year the Greek economy shrank by around 5% and this year looks like being the same or worse. So we see a country that is getting weaker and weaker in economic terms and in my view it is better that she acts now before the current policy structure makes her weaker still.

To my mind those who argue for the current status quo fail to take into account the utter failure of current economic policy in Greece. Also one scaremongering tactic that they use is to claim that Greece would be thrown out of the European Union. Whilst this is possible under the rules does anyone actually believe that the Euro-federalists in Brussels would eject a country? As this would involve the risk of ejecting others in their turn this would be an own-goal for their strategy and is accordingly an empty threat.

As ever I will be interested to read your thoughts too…

This article was written by Shaun Richards and originally published on Mindful Money under the title How the necessary Greek devaluation and default should and hopefully would happen

Tags: banking , central banks , euro , euro zone , European Central Bank , European markets , European Monetary Union , european sovereign debt , eurozone , financial crisis , Greece , Greece bail-out , Greece default , Greece's Odious Debt , greek , Greek bailout , Greek debt , Greek economy , Greek interest , Greek Parliament , Greek Prime Minister , riots
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