Default in the Eurozone

2 May 2015

Saturday


Euro sign

An introduction to brinkmanship

The emerging consensus in the financial press is that Greece must default on its debt obligations. No longer is the question, “Will Greece default?” but rather then question is, “When will Greece default?” After a pause, another question comes up: “How exactly will Greece default?” Will a Greek default mean Greece leaves the Eurozone (or, rather, the EMU, the European Monetary Union), or will Greece default and a way will be found to keep the country in the EMU? The more these questions are followed by further questions the more obvious it becomes that those asking the questions are seeking justifications and rationalizations to retain Greece within the Eurozone even as it defaults.

During the last episode of Greek default brinkmanship it became increasingly obvious that the powers that be would find a way to avoid Greek default and exit from the EMU (known by the ugly coinage “Grexit”). How do we know this? There was no significant shorting of the Euro in currency markets. Greek bonds took a hit, but they didn’t collapse. In the final analysis, no one really believed that anything dire would happen. Financial markets remained calm. Now that we are once again approaching the brink, and the drumbeat in the financial press is that Greece must default this time, again financial markets are mostly calm. The Euro is not plunging in value (the Euro is lower in value, but not at historic lows), and Greek bonds recently rallied on the assumption that the sidelining of Yanis Varoufakis would make negotiations easier. It seems, once again, that the conventional wisdom is that the worst will be avoided. In other words, a way will be found for Greece to default on its debt and to remain within the EMU so as to create the fewest waves in the markets.

There are at least two interesting things to notice about this process. The first is how far an institution (or institutions) can be pushed in a desired direction in order to obtain a desired result. The Eurozone is today a rather different entity than when the Eurozone treaties were drafted in the late 1990s and the Eurozone was only imagined. Today the Eurozone is at a crossroads, but as important as the crossroads is the long road behind it — a road of repeated and flagrant violations of the Maastricht criteria that were to govern the Eurozone, in which no nation-state has been held to account for its violations. In this context, the further violations required to keep Greece after default in the EMU do not seem particularly outrageous, as they would have seemed to those drafting the Maastricht criteria.

The “convergence” that didn’t happen

Here a little history is in order, and not the history that you are likely to get from those tying themselves in knots to try to find ways not to put the Eurozone asunder. The conditions for accession to the EMU (also known as “convergence criteria”) are known as the “Maastricht criteria” (cf. Who can join and when?):

Price stability, to show inflation is controlled;

Soundness and sustainability of public finances, through limits on government borrowing and national debt to avoid excessive deficit;

Exchange-rate stability, through participation in the Exchange Rate Mechanism (ERM II) for at least two years without strong deviations from the ERM II central rate;

Long-term interest rates, to assess the durability of the convergence achieved by fulfilling the other criteria.

Of course, these are statements of general principle and not quantifiable economic measures, but the Eurozone also has stipulated quantifiable economic measures, and there is a lot of fine print involved in these stipulations.

It is now known and generally acknowledged that Greece did not meet the convergence criteria when it was admitted into the EMU. It doesn’t take much research to find the documentation on this, but you do have to have a memory that goes back more than ten years. Also cf. The politics of the Maastricht convergence criteria by Paul De Grauwe.

Plausible deniability for the Eurozone

To understand why Greece failed to meet accession criteria but was admitted anyway one must enter into the mindset of those laying the groundwork for the EMU. The Eurozone’s monetary union was viewed as a shoe-in for success, and getting in on the ground floor was seen as something as a coup for a marginal economy like Greece, which had hitched its wagon to a star. The people of Greece had only to sit back and watch their economy soar into the stratosphere, pulled along by German and French economies. By allowing Greece into the EMU with a wink and a nod, the EU has plausible deniability when it comes to Greek entry into the Eurozone — their papers were in order, if falsified — but no one at the time really believed the Greece met the Maastricht criteria.

In all fairness, while the Eurozone did not enforce its own accession conditions for the entrance of Greece into the EMU, other nation-states within the Eurozone have repeatedly and routinely failed to meet Eurozone convergence criteria, and they have not been held to account. No consequences follow from having too large of a budge deficit or allowing inflation to get out of hand. The individual economies within the Eurozone appear to enjoy complete impunity in regard to the convergence criteria. This is how the Eurozone has arrived at its present position, which is that of trying to find excuses to allow Greece to default while remaining within the institutional structure of the Eurozone and the EMU.

Cognitive bias as a guide to political economy

To return to the two things I said above deserve to be noted in the present situation, the second thing to notice is that, however far an institution (or institutions) can be pushed, there eventually comes a breaking point — the straw that breaks the camel’s back, as it were — and the real brinkmanship going on is not whether Greece will default or whether Greece will leave the Eurozone, but whether the Eurozone will push its institutions to the breaking point. I want to pause over this ancient problem of brinkmanship and breaking points, because recent scholarship can shed light on this in an unexpected way.

A good portion of Daniel Kahneman’s book about cognitive biases, Thinking, Fast and Slow (especially Part I, section 9, “Answering an Easier Question”), is devoted to cognitive biases in which we substitute an answer for a difficult question with an easier question that we know how to answer and to which we can give a definitive answer. I don’t think that we can stress strongly enough how important (and how under-appreciated) this insight is in relation to economics and politics. All you have to do is to read the reasoning of traders in volatile commodities, and review their elaborate justifications for investments that miss the point of the biggest questions, in order to see how profoundly this affects our world today. Because it is relatively easy to talk about quantitative measures of the economy, and what these have predicted in the past, but it is very difficult to say exactly when public discontent is rising to the point that an unprecedented disruption (or a revolution) is about to occur, it is not surprising that economists and politicians alike prefer to answer the easy question, and sometimes they even convince themselves that the easy question is the only question.

The theology of the insurance adjustor

Not to worry. Insurance companies are ready for such unprecedented events. I have often reflected on the theology of the insurance adjustor who must adjudicate between events anticipated by the language of a policy and those events not anticipated or predicted, and so come under the all-embracing umbrella of “Acts of God.” Wikipedia says that, “An act of God is a legal term for events outside human control, such as sudden natural disasters, for which no one can be held responsible.” This term of art from the insurance industry can paper over a multitude of sins and cognitive biases: deal with the easy problem you’ve substituted for the difficult problem, and then when the difficult problem asserts itself, call it an “Act of God” (or the political equivalent thereof).

If we are honest, we must admit that we do not know what will become of the Eurozone and the EMU. Trying to predict the future of an enterprise so large and so complex is like trying to predict the weather: we can say pretty well what will happen tomorrow, within certain parameters, but the farther we go into the future the more our models for predicting the future diverge, until at some point different models are making inconsistent if not antithetical predictions. This is the essence of a chaotic system, and financial markets and political communities are chaotic systems.

A political and not an economic union

The Eurozone is not fundamentally economic, but political. It is a political project masquerading as an economic project, and while diplomacy often requires masquerades, when the music stops and the ball comes to an end, the masks must come off. Because the Eurozone is a political project, the glosses on its presumed political meaning are legion. I have read accounts in reputable media claiming that it was the intention of the Eurozone that, once economic unification had started, member states would lurch from crisis to crisis, and these crises would force member states to surrender political sovereignty, thus slowly transforming the Eurozone into a political union — perhaps the political union it should have been from its inception. I wouldn’t go quite this far, but such an account at least understands that only political union would make possible the wealth transfers within the Eurozone that would make the EMU workable in the longer term.

Since these is no clear idea of what the Eurozone stands for, one cannot convict the Eurozone of hypocrisy or contradiction. And there is no question that the Eurozone can find some way for Greece to default and to remain within the Eurozone, but any such arrangement will have to accept that Greece will in no sense be an equal member of the Eurozone and EMU. What, then, will Greece be?

What will become of Greece?

Quite some time ago I noted the possibility of “Euroization,” that is to say, the adoption of the Euro as a currency by a nation-state (or other political entity) not part of the EU, much less the EMU. There is precedent for this in dollarization — the use of the US dollar outside US territories. The Ecuadorian economy dollarized, and the Argentinian economy is partially dollarized, with real estate purchases traditionally transacted in US dollars and its many dollar-denominated financial instruments.

If Greece defaults but remains within the EMU, it will become a de facto “Euroized” economy that employs the Euro as its currency, but which has little real participation in the European economy. The Greek economy is not large enough, even in its presumed implosion, to seriously threaten the economies of the other EMU nation-states. If Greece defaults and exits the EMU, both Greece and the remaining nation-states of the EMU will pass through a painful adjustment, but Greece would probably be better off than languishing in the perpetual twilight of Euroized poor cousin to the EMU.

Some consequences of a Greek exit form the EMU are quite easy to guess. Tourism has been a major component of the Greek economy for some decades, and it is likely that most of the upmarket hotels patronized by foreign visitors will price their rooms in dollars or Euros, and in so doing a major sector of the Greek economy will take in hard, convertible foreign currencies. This alone will keep a substantial portion of the Greek economy in operation, even if no one wants to think of their country as nothing but a tourist destination. This is not at all unusual. Many hotels I have stayed at in South America price their rooms in dollars, and some will only take dollars. I especially noticed this in Argentina when I was there in 2010. Even as the Argentine economy stumbles under mismanagement, those who have a hotel that attracts foreign guests capable of paying in hard convertible currencies can do quite well in such an economy desperate for dollars. But while the Greek economy can subsist, after a fashion, on tourism, agriculture was always the strength of the Argentinian economy, and tourism does not represent a substantial contribution to the overall economy.

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2 Responses to “Default in the Eurozone”

  1. xcalibur said

    My thinking is that an economic union must consist of partners who are of a similar standing. There can be core and peripheral economies, but there can’t be an economy racking up debt and acting as a dead weight loss (greece) being supported by major economies (germany, france). If governments see the economic union as a free ride or meal ticket, it is doomed to collapse. In order to prevent this, Greece must be ejected from the EMU and euroized instead.

    • geopolicraticus said

      It is obvious at this point that the Greek economy is not going to be on a par with other European economies (much less other economies in the EMU) for quite some time. At the same time, it is obvious that the EU and EMU is going to bend over backward to try to keep Greece in the EMU. Compromises will be made, and I don’t mean that in the good sense of “compromises,” but rather rules will be bent or broken and the EMU will be weaker (and less economically dynamic) as a result.

      Best wishes,

      Nick

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