Understanding Greece

25/3/2015

By Martin Sandbu

Draw the right lessons from past mistakes and current stand-off

Deficits without debt, default without Grexit

Alexis Tsipras and Angela Merkel are no doubt right that it is better to talk with one another than about one another, though their meeting in Berlin on Monday has not brought more clarity to the Greece-eurozone stand-off.

But two worthwhile recent observations help to dispel some of the more facile conventional wisdom on Greece.

At the Bruegel think-tank, Guntram Wolff compares Bulgaria and Greece before the crisis, and asks the very instructive question: why is there still a crisis in Greece when there is none in Bulgaria (its GDP per capita is up almost 10 per cent on 2008)? The comparison is relevant because Bulgaria racked up bigger current account deficits than Greece. And its currency board ties Bulgaria almost as tightly to the euro as actual members (if anything, it was at greater risk of speculative bets that it would detach itself from the single currency).

Bulgaria’s external deficit consisted mostly of private financing, unlike Greece's government borrowing. But that cannot account for the difference: Ireland and Spain were also felled by private overborrowing. The answer, rather, is that Bulgaria financed itself through direct (equity) investment, not debt

Wolff highlights that FDI flows were more likely to lead to productive investment than government borrowing, which is no doubt true. I would emphasise that FDI (and even portfolio equity investment) is much more advantageous in a balance-of-payments crisis. When foreign investors turn tail, debt still has to be serviced, putting a squeeze on the economy. Equity, on the other hand, cannot be taken back. If it has been wasted, it is simply written down: the risk is with investors. A fall in Bulgaria's net international liabilities suggests this is just what has happened.

There are some hugely important lessons for the eurozone in Wolff's comparison. Among the ones he draws is that large current account deficits need not be problematic if they are financed in the right way. Another is that for future crisis prevention, the encouragement of more equity-like financing is crucial. Europe's problem is not the euro but its excessive reliance on banks and hence on debt. A "capital markets union" cannot come soon enough. (Open Europe has a useful explainer.)

Coming back to the current stand-off, the bulk of commentary takes for granted that without an agreement that extends foreign financing for Athens, Greece is headed for the euro exit. But that's too quick. What is true is that without a financing agreement, Athens is likely to default on some of its creditors. But why would it also decide to leave the euro? The standard answer is that the ECB would put such a squeeze on the Greek banking system that Athens would prefer a return to the drachma.

But there is an alternative response to ECB tight-fistedness, which Raoul Ruparel examines in a recent Open Europe blog post: Athens could impose capital controls on Greek banks. This would reduce or eliminate the need for more ECB liquidity - in effect neutering the threat of not raising the ceiling further.

Whether the Syriza government would prefer capital controls over Grexit is anybody's guess. But we should note that Ruparel takes an overly pessimistic view of the damage capital controls would cause. Tight limits on foreign transfers and cash withdrawals are compatible with fairly free circulation of deposits within the Greek banking system, so that business transactions could continue. The government could issue limited IOUs as a substitute for cash, as Wolfgang Münchau has proposed. Foreign transfers for legitimate purposes (eg imports) could be controlled as they have been in Cyprus, where constraints are about to be lifted altogether after being in place for two years - without, we should note, the country leaving the euro.

Ruparel points out that the capital controls in Cyprus were introduced to carry out a writedown of deposits. But a restructuring of Greek banks, too, may well be desirable (this is how it would work) and would make it possible to lift capital controls much faster. Considering the options, a Cyprus solution may be Athens' best bet.

Other readables:

• Matthew Klein dips into the history of economic thought and reminds us of the time when inflation, not deflation, was supposed to be a brake on growth. He takes a deep dive into the new BIS paper that we mentioned before and finds no evidence that price or wage deflation has historically been bad for the economy.
• "It sounds like an idea a stoner might come up with," writes the Upshot, in a riveting article on the District of Columbia's unintended policy of creating a gift economy in marijuana

Numbers news:

 More UK workers are resigning from their jobs, Sarah O'Connor finds, and that is good news.

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