Calm Before the Storm?

A relatively calm start to the week.  Can it last?  Almost certainly not.  It will get worse before it gets better.

A few themes popped since last Friday that are worth considering.  First is that some calmer voices have come to the forefront, arguing that a Greek exit is not really all that likely.  See Brad Plummer at Ezra Klein’s blog or Kate MacKenzie at FT Alphaville.  The general point:  Breaking up is hard to do.  No argument here – a Greek exit would be ugly for Greece, and the rest of Europe as well.  And, by all accounts, the Greek people don’t want that outcome.  The problem, however, is that the alternative, unending austerity to induce a substantial internal devaluation, is not really a solution either.

Indeed, it seems to me that on the current path, the cost of austerity will soon outweigh the cost of exit.  And we are running out of time to change that trajectory.  As I noted in my last post, it looks like the Greece fiscal situation is quickly deteriorating.  And it looks like a collapsing tourism industry will only worsen the economy, thereby putting additional pressure on deficit to GDP targets.  From FT Alphaville:

 Greece received a boost last year as the unrest in the Middle East made countries such as Egypt unattractive destinations. But it looks like German tourists won’t be propping up the Greek economy so much this summer…

…When you think of the tax revenue that might be lost from this drop in activity, it’s possibly another sign that the bailout programme may be so far off course since the elections that it could have to be renegotiated anyway.

The last bailout is quickly being overtaken taken overtaken by events.  What will be the demands of any new bailout?  If history is any guide, more austerity – and with it a higher probability of exit.

This seems to be exactly the story that Syriza party leader Alexis Tsipras is trying to sell in Germany.  To be sure, this is politically motivated, as he seeks to convince Greeks that voting for his party does not ensure an exit.  Indeed, he is pushing the opposite story – that only by tearing up the bailout agreement can Greece stay in the Euro.  From Bloomberg:

“Until when should German taxpayers pay into a bottomless pit?” Tsipras said to reporters in Berlin today after he held talks with leaders of Germany’s anti-capitalist Left Party. “It apparently flows to the Greek economy, but in reality only the banks and bankers are being financed.”…

…For Greeks, voting for Syriza “doesn’t mean that we’ll be kicked out of the euro,” he said. “It will mean a great opportunity for us to save the euro.”

A victory for Syriza would mean stability for Greece, whereas insisting on a continuation of the “catastrophic” austerity measures means a return to the drachma, Tsipras said.

I think he is right – except that to the Germans, tearing up the bailout is the same thing as exiting the Euro.  Both sides have their hands on the buttons that ensure mutually assured financial destruction, and each austerity package forces Greece closer to pushing that button.

Another theme is one I find particularly intriguing – the idea that Greece will establish an internal currency that trades side-by-side with the Euro.  FT Alphaville explains a version of this plan by Deutsche Bank’s Thomas Mayer.  The basic idea is that the government will need to turn to issuing some kind of IUO’s in the weeks ahead due to its deteriorating fiscal situation.  The new currency would trade internally and need to be exchanged for Euros to pay for imports. The exchange rate would not be one to one, of course, and internal prices would be devalued against the Euro.  To prevent the banking system from collapsing, it would need to be pulled into European supervision that guarantees Euro denominated accounts – thereby alleviating the fear of depositors that their Euro accounts would be replaced with a New Drachma, thus preventing a massive bank run.  This is only a half exit, and the goal would be to stabilize the budget to the point where the government could cease printing the New Drachmas and eventually return to the Euro.

I am not confident this would work – and particularly not confident that the Greek government could wisely use its new-found power of the printing press.  But it is a possible third way out, and this is a situation that desperately needs a third way.

Finally, Eurobonds are back on the table.  Sort of.  From the Wall Street Journal:

But next month’s elections in Greece could dramatically change the euro zone’s political calculus, analysts say. A victory by parties opposed to the bailout negotiated with the euro zone and the International Monetary Fund would sharply raise the risk of Greece leaving the currency area, and possibly prompt policy makers to adopt more far-reaching measures to contain the turmoil arising from such a threat.

These bolder policies include the creation of “euro bonds,” or debt jointly guaranteed by the euro zone that would allow weaker countries such as Spain to borrow at interest rates partly subsidized by Germany. Berlin remains staunchly opposed, though new French President François Hollande is expected to raise the topic during informal discussions at the summit.

Edward Harrison argues that Germany is not entirely opposed to the idea and see a path – an austerity-laden path – to Eurobonds. (Other views on the role of Eurobonds can be found at the NYT’s Room for Debate). The challenge, however, is that Europe doesn’t have time to wait.  Nor does it have time to wait for the other institutional plumbing, such a mechanism for Eurozone bank recapitalization under a full banking union.

Lacking a path to a real fiscal and economic union, the outcome of tomorrow’s EU meeting is likely to disappoint.  Back to the Wall Street Journal:

Without agreement on these major steps, the leaders will in the meantime back three relatively minor policy initiatives. The first is a proposal to increase the capital of the European Investment Bank, the bloc’s long-term lending arm, by €10 billion. The second proposal would ease requirements for troubled governments to use funds due to them from the EU budget.

The third is a plan to borrow money against the EU budget that would be dedicated to infrastructure-investment projects. The plan would create a pilot project using €230 million in EU budget money that could leverage funds of up to €4.6 billion. After two years, the program will be reviewed and possibly increased.

Analysts say none of these ideas is enough to have a significant, near-term macroeconomic effect in the bloc’s troubled economies.

“These ideas don’t materially improve trend growth prospects in the euro zone,” said Mujtaba Rahman, an analyst at the Eurasia Group, a political risk consulting firm. “It’s a lot of rhetoric and not a lot substance.”

Enough to look like policymakers are doing something, but a far cry from the steps needed to bring the crisis under control.  In other words, more of the same.

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