Friday, 1 July 2011

How to default – The Greek tragedy continues

By Neil McCulloch

I have sinusitis and a thumping headache.  I can’t sleep for the pain.  All I can do is think.  So what does one think about in such a situation?  Obviously, mechanisms for Greek default!  As my last blog on this argued – the current approach to the Greek dilemma will lead to a lengthy process of austerity and structural adjustment. 

The best solution, an immediate and substantial write down of Greek debts – which is politically impossible. 

The worst solution, however, – a disorderly default – remains a real possibility.  Which set me thinking.  Imagine if Greece wanted to take the “nuclear” option, drop out of the Euro and default – what would be the best (or the least bad) way of doing so?  The following steps are needed:
  1. Temporarily Close the Capital Account - Drop out and default is a huge shock – the first thing to do is to prevent people from running away with the money
  2. Establish a market value for the New Drachma (ND) - The government could do this by floating a bond denominated in ND on the market.  The Euro bids for this would determine the new exchange rate – it would be much less than 1:1
  3. Freeze all bank accounts and mandate the conversion of all Euro assets into ND at the market rate determined - Hence if you had Euro 1000 in your bank account and the new rate was 2 New Drachma to 1 Euro, then the bank would replace your Euro 1000 with ND 2000.  Similarly if you had a loan of Euro 1000, this would be replace with a new loan of ND 2000.  In this way all domestic assets and liabilities are inflated by the new exchange rate leaving everyone in exactly the same position as before. 
  4. Require all wages and prices to be in ND - All shops must convert their Euro prices into ND; all wages must be paid in ND.  Both should be increased by the publically announced exchange rate.
The above steps have to be taken very quickly – within a week – to ensure that people can access the new cash and use it for payments.

So what follows is the clever bit ... or, as all the other European countries will call it, the downright dishonourable bit.  Greece needs a reduction in its debt, a large reduction, to bring it back to a sustainable situation.  The European Central Bank is, wrong-headedly, doing all it can to prevent any kind of debt reduction, for fear of contagion around the union.  The best it can manage is to ask private creditors to roll over debts and sadly I don’t think there will be lots of volunteers. But if Greece is to default – this is the way to do it.

4 comments :

JamesG said...

It is very sad to see the situation on the streets of Athens, the anger of the population and the obvious frustration of the back bench MPs. The biggest problem for the civil society organisations and demonstrators is they seem to suggest no alternative. But this default plan is just what they could be calling for.

Anonymous said...

I wonder, if UK was in Greek place, you would suggest the same think, so easily?

Ricardo Santos said...

Some interesting ideas.
A less known fact is that, for some purposes, the irrevocable exchange rates of the former national currencies of the Eurozone against the euro still holds. That means that 1 Euro still has the value of 340.750 Drachmas. I have to say, Neil, that this is far more than the 1:1 parity you mentioned and one that makes the hypothetical transition to the ND even more catastrophic. Three questions keep nagging me: 1) Why does it seem that the once triple A public debt can only by either payed or defaulted against? Why is debt roll-over considered an intermediary step to default? That isn't what happens with firms, is it? 2) Why do economic analysts keep saying that public accounts only move at the rate of the economy? If the public expense reduces and taxation increases, doesn't that increase public accounts beyond what economic growth allows? 3)When are we to see placed into force the needed fiscal solidarity mechanism the theory of "Optimum Currency Zones" recommended in the 1960s?
Maybe it would help to ask these questions before arguing on the inevitability of Greece's default.

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