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Returning to the drachma wont save Greece

Returning to the drachma won't save Greece

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It's getting harder and harder to see a good outcome for Greece. And harder and harder to see Alexis Tsipras' government really trying to deliver one.

As economists looking at the euro currency area will quickly tell you, this was a monetary union destined to run into problems. It functioned just so long as markets believed that countries within it were effectively backing each others' debt liabilities, and came close to collapse as soon as that myth evaporated in the aftermath of the global financial crisis.

Only the European Central Bank's belated decision to take its role as central bank seriously under Mario Draghi, first with his (untested) commitment to open-ended bond purchases under OMT and latterly through the ECB's QE programme, helped to calm fears of a domino effect of cascading sovereign defaults in troubled Eurozone countries.

If you want to know what that looks this, here is a chart of European bond yields from 1993-2011 (h/t Frances Wooley at WCI):
However, for countries that were facing more severe financing problems and had no access to bond markets the ECB's efforts were only of indirect benefit in preventing deeper slumps elsewhere in the region. Instead Greece, which had misled both the markets and its Eurozone peers over the scale of its borrowing in the years leading up to the crisis, was given a huge bailout in 2010 worth €110 billion and placed in a reform programme under the supervision of the European Commission, the IMF and the ECB.

The result of this, whether European politicians wanted to admit it to themselves or not, was the de facto suspension of Greece's full rights of membership to the monetary union.

This occurred because, for one thing, the independent central bank and Greek banks' lender of last resort also happened to be a creditor and as such sat on the wrong side of the negotiating table when the country's reform package was being discussed. In essence, although Draghi has done his best to extricate the institution from the political negotiations during the current rounds of talks on Greece's bailout, it has been politicised over the course of the past five years (not least as its former President Jean-Claude Trichet was apparently instrumental in resisting efforts to restructure Greece's debt).

Secondly, by allowing for a transfer of Greece's debts from the private sector to the official sector European leaders, the region's technocrats and the IMF made it all but impossible for the country to take a strong negotiating stance with lenders without risking its euro membership. In other words, it set other European taxpayers'  interests against those of the Greek government.

And that's a great shame. Greece has undertaken a huge structural adjustment and, at least mid-way through last year, looked to be on the road to a hard won recovery (see chart below).
Yet there were clear signs that public support for the reform programme was failing. The anti-austerity party SYRIZA had been gaining in the polls after coming second to the centre right New Democracy party in 2012.

Although the government's balance sheet was modestly improving, the economy was still only beginning to limp out of its slump and unemployment remains at over 25% to this day.

Even if Greece's interest bill wasn't much higher than its larger Eurozone neighbours, following the 2011 and 2012 restructuring that many had considered an inevitability from the start, its politicians looked increasingly like they needed a symbolic effort from the institutions-formerly-known-as-the-Troika to show that the people's suffering was both seen and worried about.

Unfortunately, by the time SYRIZA came to power in January this year the promises they had made during the election called for much more than the creditors were likely to deliver. But if there was any doubt over the depth of the public's lost appetite for further austerity measures, the overwhelming No vote to the creditors' most recent offer in last Sunday's referendum should put them all to rest.

The barrier to implementation of a new reform programme may not simply be an intransigent left-wing government in Athens, but an exhausted populace unable anymore to vote for the certainty of further financial insecurity even when the alternative is the high likelihood of extreme financial instability.

Now it seems we are seeing the country's euro membership suspension threaten to become an expulsion. Despite my sympathies for those who would argue that the country has been hamstrung by a succession of poorly constructed and chaotically implemented reform programmes, I would nevertheless consider such a result a great tragedy.

There are those who believe that a Greece, freed from the yoke of the euro, could simply devalue and ultimately spring back to economic health. This, I'm afraid, is pure folly.

If you want to see why, you need only look at the response of the Greek economy to falling wages over the past five years. Despite significant falls in average real wages in Greece, exports have been slow to pick up (h/t Bruegel):
Why did the expected export boom fail to materialise?

Partly, it reflects a sharp drop in Greek labour productivity. Whether his can be attributed to the poor construction/implementation of the Troika's reform programme or alternatively to the country's rigid product markets, clientelist political culture and labour market rigidities is not the most important question at this stage.

The real question is why we should expect anything different from a massive currency devaluation, that promises to be massively disruptive in the short term even if it could be helpful over the medium to longer term. After all, do we really think that import substitution (whereby goods that used to be brought in from abroad get bought from domestic producers instead) and, especially, the country's reliance on oil imports to meet its energy needs can be solved without causing widespread hardship for the most vulnerable in society?

Oh, and that's not to mention the loss of the the IMF safety net enjoyed by other troubled states as Greece is already in arrears and could well end up in outright default if the present situation is not resolved amicably between the country and its creditors.

If stories today that SYRIZA's new finance minister, Euclid Tsakalotos, turned up at the Eurogroup meeting without new proposals prove true then I'm afraid this speaks volumes about his government's priorities. The one thing we know is that the 61% of Greek people who voted No in the referendum were not voting for further hardship, whether inflicted by Troika memorandum or radical leftist principle.

Prime Minister Alexis Tsipras must now work tirelessly to prevent his country from spiralling out of the euro area on terms that he cannot control and with impacts that he is in no position to offset.

If the European Commission fails to come through with the promised symbolic gestures during the next bailout negotiation then that will be the time for harsh words — though even then dubbing them "terrorists" would be going some distance over the line. Right now, both Greece and the rest of Europe could simply do without the petulance of the past few days.

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