Greece: it can’t get *that* much worse, can it?

18/6/2015

By Matthew C Klein

Conventional wisdom holds that it would be an unmitigated disaster for Greece if it left the euro. This is, after all, why the country has continued to cling to the single currency despite the catastrophic decline in employment and output. But what if those costs have been grossly overstated?

An intriguing new note from Gabriel Sterne at Oxford Economics argues that, judging by the historical record, things really can’t get that much worse. According to Sterne, staying in the euro promises only years of stagnation and crushing joblessness, while leaving offers a chance, even at this late date, of rapid growth and the end of the depression that began seven years ago. In particular, he argues that leaving the euro would provide a fillip to the private sector’s balance sheet, boost trade competitiveness, and, perhaps most importantly, end the uncertainty over default and devaluation that has been choking off credit and investment.

To be clear, there are still plenty of reasons to think that, at least in the short-term, default and devaluation would be extraordinarily painful. For all the money that has already left the Greek banking system, there are still about €128 billion of Greek private-sector deposits sitting in Greek banks:

Those euros — many of which are probably held by middle-class savers and the elderly, rather than the financially sophisticated who long ago shifted funds into Switzerland or Germany — would plummet in value.

Meanwhile import costs would soar, and since Greece is a net importer of food and energy, this would probably hit the poor hardest. If Greece were ejected from the European Union and lost access to the single market and the structural and cohesion funds, it would suffer even more.

The Greek banks might be able to survive depending on what happens to their liabilities to the Eurosystem but it isn’t encouraging that more than half of their regulatory capital comes from deferred tax assets, which only have value if the banks are profitable and the Greek government has cash to pay. (In fact, the lenders could be in trouble even if Greece stays on the euro, depending on your assumptions about non-performing loans and the value of DTAs.)

Then there are the possible ramifications of what all this would do to civil society and politics, which could further undermine living standards.

However…

There is a certain logic to recessions — or in this case, depressions — and the subsequent recoveries. Prices generally can’t fall below zero. In fact, there is usually a point well before then when it makes sense even for shell-shocked savers to start buying assets because they are so ridiculously cheap, and for companies to start hiring workers from the mass of unemployed.

The tragedy in Greece, and, to a lesser extent, other troubled countries throughout the euro area, is that specific policy mistakes interacted with a flawed institutional structure to prevent this recovery process from happening sooner and quicker. Tight monetary conditions, a debt overhang, an overvalued exchange rate, fiscal austerity, and, last but definitely not least, lingering uncertainty about currency re-denomination and default, have all interacted to prevent the economy from returning to something vaguely resembling normal.

Andrew Kenningham of Capital Economics points out that devaluation works best when credit is tight and unemployment is high, which happens to correspond exactly with the circumstances in Greece today. (There is a convincing argument to be made that Greece’s exports have failed to respond to the collapse in relative labour costs because this occurred at the same time that trade credit disappeared.)

Consider the gap between Greece’s current level of economic activity and levels that might be considered “normal” based on different pre-crisis trend paths. As you can see in Sterne’s chart below, even the most pessimistic assumption holds that the Greek economy is running about 6 per cent below where it “should” be, which implies a lot of room for growth once constraints are removed:

This suggests that devaluation wouldn’t simply lead to higher nominal prices but actually boost real output.Leaving the euro would allow the Greek government to print money, improve competitiveness, and end uncertainty about currency risk. (You let the currency float and then you’re done.)

Of course, abandoning the single currency isn’t necessary to restore growth and employment, and probably not even the best way, but in the absence of significant changes in the policies emanating from Frankfurt, Brussels, and Berlin, it could be the most practical path.

To get a sense of how harmful persevering within the euro has been, it helps to compare Greece’s fate with a database from the International Monetary Fund of 137 systemic banking crises. Sterne did this and found that the severity of the Greek depression (in dollar terms) has already been worse than 95 per cent of other crises:

The decline in Greek GDP has precedents, but only in wars, commodity collapses, and Argentina. Even without exit, it is likely to have been in the bottom 4% of crisis recoveries seven years on if IMF projections for 2015 prove correct. Greece’s $-GDP will likely have declined at least 42% between 2008 and 2015. Below Greece are five extreme cases:

• Ghana (1982), whose $-GDP never recovered for years after plummeting 80% in two post-crisis years, partly related to a commodities slump;
• War-torn DR Congo, whose $-GDP fell 48% in the seven years after 1991;
• War-torn Ukraine, whose $-GDP has fallen by over 50% since the 2008 financial crisis;
• Guinea Bissau’s 1995 crisis was not so bad, but the civil war that followed meant $-GDP had fallen by over 50% five years later;
• Argentina (NB for crises in 1980 and 1995, not 2001)

Sterne believes, not unreasonably, that this severe decline already incorporates the costs of fiscal retrenchment, the banking bust, and the debt overhang. Devaluations usually occur much earlier in a crisis, so the sharp initial drop in GDP typically associated with floating the currency may not apply to Greece.

But suppose you think the Greek economy would lose an additional 30 per cent in dollar terms by 2016 if the country left the single currency today, and then only gradually begin growing again in 2017, without any sharp snapback. (The dashed blue line in the chart below.) According to Sterne’s analysis of the IMF data, you are implicitly expecting Greece to endure one of the absolute worst 12-year growth performances of any country in the world since 1980:

That seems utterly implausible. Greece would somehow do worse than countries that were either highly sensitive to declines in commodity prices and/or in the midst of violent civil wars. As Sterne puts it, if things get this bad it would be a “disgrace” for Europe.

Sterne also puts the question of social stability and deposit flight in perspective:

Argentina in 2001 is one of the most commonly cited historical examples of capital flight. As a % of pre-exit GDP, the decline in deposits in Greece would be around six times as large at the point of exit.

As we’ve written before, the Greek private sector, in the aggregate, has a substantial net foreign asset position, especially if you reasonably assume that a goodly portion of the €105 billion in household and non-financial corporate deposits that have already left the Greek banking system since 2009 haven’t been used for kindling. The “cash on the sidelines” metaphor is often misused, but in this case it could be quite apt, especially if the uncertainty surrounding re-denomination were finally removed.

One example of potential bargains to be snapped up after exit could be the Greek equity market. It currently trades at less than 20 per cent of its pre-crisis price, although a bunch of that decline reflects the collapse in profitability of listed Greek companies:

While share prices could certainly fall further as an initial response to exit, the profit outlook should improve in the event of devaluation if for no other reason than that most Greek companies have most of their assets outside the Greek financial system, in contrast to their liabilities. Similarly, a cheaper currency also boosts the local value of export earnings. Even if Greece’s real export volumes refused to grow in response to this stimulus, which seems hard to believe, exporters would still be better off simply because revenues would rise relative to costs.

None of this should be read as a recommendation for Greece to pull the plug and leave now. There are other options that could be better for everyone in Europe, starting with official sector debt forgiveness, a relaxation of austerity that allows for additional public investment, and the inclusion of Greek assets in the ECB’s QE programmes. Add in a credible commitment to establish euro area-wide deposit insurance, unemployment benefits, and pensions, all backed by a central treasury and eurobonds, and you start to get somewhere.

My colleague Martin Sandbu has noted that the Spanish government recently provided an outline for how to do all this, although he also noted that the Germans and French governments are unenthusiastic. In fact, it’s not clear whether enough Europeans in any country have the necessary appetite for that kind of further integration. If not, then a Greek exit starts to look pretty sensible, especially for Greeks.

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