Thursday, October 27, 2011

Default, decouple, devalue

Greece, as may have been mentioned once or twice, is pretty much screwed. Its debts are so monstrously disproportionate to its economy that it is not feasible that they can be repaid in full. It is, therefore, not a question of whether Greece will default, but in what circumstances it will do so.
There's growing support for the triple 'd' option of default, decoupling from the Euro and devaluation. There is, however, one point that should be raised in this regard. When Jeffrey Miron writes:
If Greece defaults, the country gets immediate relief from the crushing interest payments on its debt, leaving it with a relatively modest primary deficit which excludes the big interest payments Greece is faced with now.
In such a scenario, the pressure for austerity would therefore diminish. This would allow Greece to choose policies that encourage growth, rather than ones that shrink the deficit but retard growth by imposing higher taxes.
I think he might be missing something. As he acknowledges, Greece is running a primary deficit - i.e. even if you ignore interest payments on its debts. So while a default would free Greece from paying that interest, and thereby greatly reduce its budget deficit, it wouldn't eliminate it entirely. Greece would still be spending more than it earned. There are four ways of dealing with this. Spend less, earn more, borrow the difference or print money to make up the difference. Option 3 will definitely be out - Greece has just repudiated its debt, how keen would you be to lend it more? Options 1 & 2 are the austerity measures that Miron deplores.
That leaves option 4 - printing money. To be able to do this, of course, Greece needs to decouple its currency from the Euro - a task that is far from straightforward or painless. Assuming, however, that it can be done, there will inevitably be substantial downward pressure on the value of the new Drachma (that's rather the point, in fact - the third 'd' is for devaluation). Adding to that existing downward pressure by substantially increasing the money supply to pay for current spending really increases the risk of hyper-inflation which, when coupled with the fall in living standards that's going to happen in Greece over the next few years, would really be extremely unpleasant.
Conclusions? Greece is screwed. There are no neat solutions to this problem. I'm afraid that the time is coming when we're all just going to have to bite the bullet and take it.

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