Monday, April 20, 2015

Default ≠ Drachma

I've been saying for a while that people should stop assuming that a Greek default implies leaving the euro for a new currency. Much of the media coverage of the negotiations continues to assume that the two are inseparable -- that, in effect, the negotiations are over Greece remaining in the euro system. But there is no logical necessity for a default to be followed by the creation of a new currency; indeed it's hard to see any reason why the former should lead to the latter.

Finally the consensus that default must mean exit seems to be breaking down. Here's John Cochrane:
Please can we stop passing along this canard -- that Greece defaulting on some of its bonds means that Greece must must change currencies. Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone.
Cochrane's political views are one thing, but he is a very smart guy. And in this case, I think the Walrasian view of money as numéraire is helpful. It's important to remember that euros are not physical things, they are simply units in which contractual commitments are denominated.

And now in today's FT, Wolfgang Munchau writes:
The big question — whether Greece will leave the eurozone or not — remains unanswerable. But I am now fairly certain it will default. My understanding is that some eurozone officials are at least contemplating the possibility of a Greek default but without Grexit. ... 
On whom could, or should, Greece default? It could default on its citizens by not paying public-sector wages or pensions. That would be morally repugnant and politically suicidal... it could default on the two loans it received from its EU partners, though it is not due to start repaying those until 2020... Defaulting on the IMF and ECB is the only option that would bring genuine financial relief in the short term. ... 
Default is not synonymous with exit. There is no EU ruling that says you have to leave the eurozone when you default on your debt. The link between default and exit is indirect; if a country defaults, its defaulting securities are no longer eligible as IOUs for the country’s banks to tender at ECB money auctions.... 
So to default “inside the eurozone” one only needs to devise another way to keep the banking system afloat. If someone could concoct a brilliant answer, there would be no need for Grexit. 
... The economic case for a debt default is overwhelming. ... Full servicing would require huge primary surpluses — that is, surpluses before payment of interest on debt. It would leave Greece trapped in a debt depression for a long time. The scheduled primary surplus for 2016 is 4.5 per cent, which is bordering on the insane. Athens absolutely needs to default. At the same time, there is a strong case for remaining in the eurozone.
This hits all the key points. First, there is no logical connection between defaulting and creating a new currency. (Probably better to use that wording, rather than "exit.") Second, default would open up significant space in Greece's fiscal position, and would not hurt the its external position. This follows from the fact that Greece currently has a substantial primary surplus and a slight positive trade balance. [1] Third, the only reason there is any link is that default might cause the ECB to cease accepting new liabilities from Greek banks, and it might be hard for the Bank of Greece and/or Greek government to take the ECB's place under the existing rules of the eurosystem. So, fourth, the real problem with default is the need to ensure that the Greek payments system continues to operate even if the ECB tries to sabotage it. 

The phrasing of that last point might seem hyperbolic. But imagine if, during the Detroit bankruptcy negotiations, the Fed had announced that if the city did not pay off its creditors in full, the Fed would use all its regulatory tools to shut down any banks operating in the city. That's a close analogy to the situation in Europe.

Maintaining interbank payments within Greece does not necessarily require the Greek government to issue any new liabilities. And it certainly doesn't require that Greek bank accounts be redenominated. All that is necessary is that if someone with a deposit in Greek bank A wants to make a payment to someone with an account at Greek bank B, there is some system by which bank A can transfer a settlement asset to bank B, acquiring the asset if necessary by issuing a new liability. The technical aspect of this is not challenging, and even the practical aspect, since the Bank of Greece already performs exactly this function. As far as I can tell, the only problem is a political one -- given that the Bank of Greece is run by holdovers from the former Greek government, it's possible that if the ECB told them to stop facilitating payments between Greek banks they would listen, even if the Greek government said to carry on. 

Now some people will say, "oh but the Treaties! oh but the Bank of Greece isn't allowed to accept the liabilities of Greek banks if Brussels says no! oh but the ELA rules!" [2] Obviously I think this is silly. In the first place, the "rules" are hopelessly vague, so if the ECB's does shut off liquidity to Greek banks in the event of a default, that will be a political choice. And on the other side, Greece is a sovereign nation. It may have delegated decisionmaking at the Bank of Greece to the ECB, but that also was a political choice, which can be reversed. More to the point, the rules definitely don't allow for exit. Nor for that matter do they allow for default -- and as Munchau correctly points out, cuts to the salaries and pensions of public employees are also a form of default. Rules are going to be broken, whether Greece creates a new currency or not. And it is not at all clear to me that the demands on the Greek state from recreating the drachma, are any less than the demands from maintaining payments between Greek banks in the absence of ECB support -- which is all it takes to default and continue using the euro. If anything, the former seems strictly more demanding than the latter, since Greece will need its own central bank either way.

This all may seem pedantic, but it is important: The threat of ejection from the euro is one of the most powerful weapons the creditors have. And let's remember, the only direct consequence of a breakdown in negotiations, is a default on Greek government debt.

Now there is another argument, which is that exit is positively desirable since a flexible currency would allow Greece to reliably achieve current account balance even once income growth resumes. I think that is wrong -- but that's a topic for another post. (I discussed the issue a couple years ago here.) But even if, unlike me, you think that a flexible exchange rate would be helpful for Greece, it  doesn't follow that that decision is bound up with the debt negotiations.



[1] It is possible that the apparent primary surplus is due to manipulation of the budget numbers by the previous government. I think that the arguments here would still apply if there were really a primary deficit, but it would complicate things.

[2] Or, "oh but that would be ungrateful." In one of its more disingenuous editorials I can recall, the FT last month wept crocodile tears over the fact that "default on Greek debts would deter wealthier voters from ever again helping their neighbours in financial distress." Apparently German banks didn't care about the interest on all the Greek government bonds they bought; they only lent so long out of kindness, I suppose. Also, it doesn't seem to have occurred to the editorialists that deterring the financing of large current account deficits might be a good thing.


UPDATE: This seems important:
A country that defaults would not have to leave the euro, the European Central Bank's vice president said on Monday...  
Vitor Constancio discussed the possibility of a debt default and controls on the movement of money, saying neither necessarily meant a departure from the currency bloc. "If a default will happen ... the legislation does not allow that a country that has a default ... can be expelled from the euro," he told the European Parliament... 
Constancio also touched on the possibility of capital controls. "Capital controls can only be introduced if the Greek government requests," he said, adding that they should be temporary and exceptional. "As you saw in the case of Cyprus, capital controls did not imply getting out of the euro." ... 
"We are convinced at the ECB that there will be no Greek exit," he said. "The (European Union) treaty does not foresee that a country can be formally, legally expelled from the euro. We think it should not happen." ... 
"If the state defaults, that has no automatic implications regarding the banks, if the banks have not defaulted, if the banks are solvent and if the banks have collateral that is accepted," Constancio said.
Maybe they were worried that Greece would call their bluff. Or who knows, maybe the culture of the place has changed under Draghi and they are no longer ready to serve as austerity's battering ram. In any case, it's hard to see this as anything but a big step back by the ECB.


UPDATE 2: Martin Wolf is on board as well. (Though he doesn't like my Detroit analogy.)


20 comments:

  1. Just to throw in a few relevant numbers.

    First of all what is highly important is the events of default clause in the refinancing agreement between the Greek government and the EFSF. More or less any failure to pay by the Greek government on its liabilities (towards creditors such as the IMF, ECB, post-PSI bondholders) will allow the EFSF to declare its loan to Greece in default as well.

    Nevertheless, both IMF and ECB SMP holdings (which are Greek-law bonds) carry a 30-day grace period while the Greek has considerable leverage in the case of the ECB since it can use its own courts and laws to avoid immediate payment on ECB bonds.

    For Greece to exit the Eurozone it is necessary for the ECB to withdraw ELA financing. Yet Greek banks do not use governmet bonds/T-Bills for refinancing (at a significant level) but rather EFSF notes or own-issued bonds of Pillars-2/3 of a Greek law (Pillar-2 provides government guarantee on bank bonds while Pillar-3 involves covered bonds which also carry a government guarantee). See for instance NBG results. So legally, since the bonds have been issued by the banks themselves, it is not easy for the ECB to force BoG to stop accepting them, only maybe ask for increased haircuts.

    Overall, a Greek government 'failure to pay' can be quite complicated in its legal aspects and will probably lead to capital controls but not to an automatic Grexit.

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  2. Kostas-

    Thanks, this is helpful.

    More or less any failure to pay by the Greek government on its liabilities (towards creditors such as the IMF, ECB, post-PSI bondholders) will allow the EFSF to declare its loan to Greece in default as well.

    Allow, but not require, right? In general, it seems like default will not be a decision of the Greek government, but of the creditors -- presumably as punishment for insufficient "progress" on formally unrelated policies like collective bargaining rights and the minimum wage.

    legally, since the bonds have been issued by the banks themselves, it is not easy for the ECB to force BoG to stop accepting them, only maybe ask for increased haircuts.

    This is good to know. Where would you recommend I go to learn more about the specifics?

    a Greek government 'failure to pay' can be quite complicated in its legal aspects and will probably lead to capital controls but not to an automatic Grexit.

    Glad to hear that this is your view as well.


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    1. Unfortunately I 'm not aware of any good references on the Pillar-2/3 bonds. One has to do his own research on the subject.

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  3. Also, I don't know if this is something you have any insight into, but the big question I am wondering about is, if the ECB wanted to terminate liquidity support to Greek banks and the Greek government wanted it to continue, the Bank of Greece would presumably find itself in a legally ambiguous position. Do we have any idea which side the BoG leadership would lean towards?

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    1. It's too much of a gray area for anyone to answer (plus I m not a lawyer anyway).

      In any case, 'terminating ELA' is more or less the same as capital controls. Since ELA financing has been used to finance increased Target2/cashnotes liabilities there isn't any way for the Greek banks to find the funds to cover their exposure towards BoG.

      So terminating ELA (by not accepting Greek government guaranteed securities) would just mean a default by Greek banks although BoG would retain the relevant securities. The last point is important in rejecting any scenario involving deposit haircuts like the ones which happened in Cyprus.

      As you can understand it is really difficult for the Eurozone to 'expel' Greece from the Euro. It will mostly be a matter of Greece having to find a way to keep functioning after some ugly developments involving failure to pay on its liabilities and changes in the ELA collateral framework.

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  4. I think that it is true that a Greek default doesn't imply a greek exit from the euro: I'm thinking of something like eurodollars.

    However, it seems to me that it is the eurocrats who are pushing this line, so maybe they would try to force Greece out by other means if Greece defaults.

    I don't know what kind of weapon they could use though.

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    1. I think that it is true that a Greek default doesn't imply a greek exit from the euro: I'm thinking of something like eurodollars.

      Right, that's a good comparison.

      However, it seems to me that it is the eurocrats who are pushing this line, so maybe they would try to force Greece out by other means if Greece defaults.

      Very possibly. But on the other hand, maybe they are pushing this line because the idea that default = exit is the biggest threat they have.

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  5. "the FT last month wept crocodile tears over the fact that "default on Greek debts would deter wealthier voters from ever again helping their neighbours in financial distress."

    About your footnote number two, the unintended consequences of the harsh IMF structural adjustment programs after the East Asia Financial Crisis of the 1990s is the savings glut and the determination of China and others of never being put in the position of having to go to the IMF.

    The recent blog discussion with Bernanke about the SecStags and low interest rates centered on the fact that the rest of the world doesn't want to borrow from the West. Maybe it's partly because of their thug-like collection policies. Spain and Greece won't want to go through this again I bet.

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    1. That's right. That's actually part of the point of the working paper I linked to the other day.

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  6. "All that is necessary is that if someone with a deposit in Greek bank A wants to make a payment to someone with an account at Greek bank B, there is some system by which bank A can transfer a settlement asset to bank B, acquiring the asset if necessary by issuing a new liability."

    What about payments to non-Greek banks in other countries?

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    1. Presumably they will be impossible, unless they are routed through the BoG or some other institution with access to non-euro currencies. In other words, capital controls -- which would be a very good thing for Greece IMO.

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    2. I am not sure I agree with the last sentence. Take a look at today's balance of payments data. Greece might have achieved a positive annual BoP position but it still has significant needs on a monthly basis to finance short-term external deficits (especially during the first half of the year). Thus a liquidity provider of last resort is necessary even if the Greek government were to default on all its liabilities.

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    3. I hadn't thought about the seasonal issue. You might be right, in which case more comprehensive exchange controls and foreign exchange rationing might be needed. On the other hand, it seems like you'd effectively have that already if Greece is kicked out of TARGET2.

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    4. I do not think that there's actually a legitimate way of being 'kicked out of Target2', only changes on the collateral framework of BoG and capital controls.

      The good scenario is that Greece remains connected and ends in the ERM II mechanism as Denmark and can draw on (unlimited?) euro credit lines in order to maintain its exchange rate within certain bounds with the Euro. The bad scenario is that it remains connected in the same way as other EU countries which need to have positive balance on their central banks accounts with the Eurosystem.

      As for the current Target2 liabilities my view is that they will become drachmas (as part of the BoG balance sheet) and constitute 'foreign reserves' of the Eurosystem. But that's as good a guess as anyone's else.

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  7. If ELA funds have been used for greek payments to other EZ countries through TARGET2, does ELA cutoff also mean cutoff from TARGET2? If the greeks don't have access to the TARGET2 system it is hard to see how one could say they are still part of the Euro Zone.

    The whole default debate seems like a red herring. The passive wording of "Greek Exit" is annoying. What we are talking about here is an active political threat to kick Greece out of the Euro, not a passive economic exit.

    The Euro Zone is a political construct, and greek could get kicked ou

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    1. What we are talking about here is an active political threat to kick Greece out of the Euro, not a passive economic exit.

      I agree with this. But I think we have to think more critically about what it means to be "in the euro system." There are a number of distinct pieces and there is no reason in principle a country can't participate in some but not all of them, just as some but not all countries in the EU participate in the euro system. It's not a binary, I don't think.

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  8. You may be busy grading papers.

    Dan Davies:

    https://medium.com/bull-market/greece-the-next-steps-and-scenarios-576aedb408d4

    Congrats from Mike Konczal:

    "Personally, I’m happy that it quotes J.W. Mason’s work on profits and borrowing shifting from investment in a previous era to cash leaving the firm now. This issue is a major piece of our Financialization Project here at Roosevelt, and we will continue to develop it in the future."

    http://www.nextnewdeal.net/rortybomb/senator-baldwin-asking-sec-questions-about-disgorge-cash

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    1. I've lost patience with Davies on Greece. He keeps presenting the situation as Syzria having all the power and the Euro Institutions having no agency.

      The reason Greece is not running a large primary surplus is because the troika designed it that way. They did this even with a nice compliant government in power with New Democracy and they didn't let up on the austerity. Read Schuable's statements, he is very clear on austerity and wage deflation being a policy goal.

      These are real people causing real suffering, but Davies acts like the Euro Institutions are a force of nature.

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  9. I wonder though if the widespread belief that default implies Grexit could result in runs on the banks in the event of a default? Even if there "should" be no problem with keeping the Greek banking system running after a default, if people think that there will be, that belief itself could produce the problem.

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    1. This is the whole point of the Grexit talk. The EU maintains political power over Greece by threatening financial crisis if the government doesn't behave.

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