Greece really might leave the euro

By Matt O'Brien January 30 at 7:41 AM

The Washington Post

The world's worst portmanteau is back: Grexit.

That's short for "Greek exit," as in Greece leaving the euro. And it's once again a possibility now that the left-wing, anti-austerity party Syriza has won power in the latest elections. The risk, as I've said before, is that the rest of Europe is in good enough shape that Germany finally thinks it can let Greece leave, and Greece's budget is in good enough shape that it finally thinks it can leave too. Neither of them wants that, but neither of them doesn't want it so much that they'd do anything to avoid it—so both might call each other's, as it turns out, non-bluffs if Syriza tries to force Germany to renegotiate Greece's gargantuan debt.

Cue the market freakout in three, two, oh, it's already here? Why yes, yes it is. Greek stocks fell 11 percent on Tuesday, another 9.2 percent on Wednesday, before stabilizing up 3.2 percent on Thursday. Three-year borrowing costs shot up to 16.9 percent. And worst of all, Greek banks collapsed between 30 and 45 percent in just the last week. That's enough, as we'll see in a minute, to make it much more likely that Greece leaves the euro.

Now, as far as panics go, this one is pretty well-justified. That's because Syriza hasn't just taken a hard line against austerity, but picked the equally hard line, though right-wing, Independent Greeks as its coalition partner, ahead of less confrontational but more ideologically simpatico alternatives. The game of debt chicken, in other words, is very much on.

But the weird thing about Greece's debt, as Dan Davies points out, is that it doesn't really matter. Greece, you see, owes €317 billion, or 175 percent of its GDP, but that might as well be eleventy billion kajillion euros—it's about as meaningful and likely to be paid back. Why? Well, the first thing you should know about Greece's debt is that 75 percent of it is held by the "official sector." That's an alphabet soup of lenders that includes the IMF, ECB, EFSF, and European governments. And unlike private sector lenders, they don't care about maximizing their returns, but rather looking like they're maximizing their returns. That means that under no circumstance will they reduce the face value of what they're owed ... but they will reduce interest rates to almost zero and extend maturities to infinity and beyond. So suppose, for example, that you lent me $100 for 10 years at a 5 percent interest rate. If you were Germany, you wouldn't take anything less than that $100 back, but you might give me 30 years at just a 1 percent interest rate to repay it instead. That's still a big help.

The good news is that Greece's debt payments have already been cut a lot. The bad news, though, is that Greece's debt payments have already been cut a lot—so there's not much left to do. Greece, economist Zsolt Darvas explains, only owes 0.56 percent interest on a big chunk of its debt, doesn't owe any on another for 10 years, and gets paid back all the interest it sends to the ECB. Not only that, but most of its debt is already pretty long-term. That's why, despite its 175 percent of GDP of debt, Greece only has 2.6 percent of GDP of debt payments.

So all they can do now is fiddle some more with the interest rates and maturities. Maybe turn 0.5 percent rates into 0.2 percent rates, and 30-year bonds into 50-year bonds. That's not going to free up a lot of cash, though. Maybe 1 percent of GDP. Maybe a little more if the ECB starts buying more Greek bonds as part of QE. This last part is actually pretty clever. The ECB can only buy a country's bonds if it owns less than 33 percent of them, but it owns 34 percent of Greece's right now. That means Greece should want to pay the ECB back right now, so that the ECB can buy more of its debt. After all, when the ECB buys Greek bonds from Greek banks, that turns debt that Greece had to pay interest on into debt that it doesn't have to. So, in Greece's case, QE trades debt payment for debt relief.

This is a deal Europe could, and probably would, support. Indeed, even Finland's Prime Minister, who's been more opposed than most to debt forgiveness, has said he'd be okay with giving Greece more time to pay back what it owes. Europe's dirty little secret, though, is that more time will eventually become all the time in the world. Today's 30-year bonds with 0.5 percent rates will become tomorrow's 50-year bonds with 0.2 percent rates, and then, at some point, zero-interest perpetual bonds, aka debt that you don't have to pay interest or principal on, aka not debt at all. Everybody knows this, but nobody can say it, because German taxpayers wouldn't like hearing that Greece will never pay back what it owes, that everyone's debts will be thrown together when there's a United States of Europe. (Oops, pretend you didn't hear that). And that's why Greece's debt is pretty irrelevant. It's a big number that Greece can't pay back, so who cares how big we're pretending it is?

Well, Syriza does. They say they want to cut Greece's debt in half. The only problem is that's not going to happen, and even if it did, it wouldn't help much. The question, then, is whether a deal that just cuts interest rates and extends maturities would be enough for them. Another 1 percent of GDP of spending wouldn't save the Greek economy, but it would save a lot of Greek people from extreme poverty. Syriza would have enough money to give food stamps to the hungry, healthcare to the sick, and electricity to people who can't afford theirs anymore, just like it campaigned on. So would this be enough? Maybe not. Greece's austerity is bigger than its debt payments, so just reducing those payments might not reduce its austerity as much as Syriza wants. That leaves one last question. Why is Greece, with 25 percent unemployment, cutting more spending than is absolutely necessary? Easy: Because Europe is making it.

Greece, you might be surprised to learn, doesn't need Europe's money to keep its budget afloat anymore. But it does need Europe's money to keep its banks afloat. And that, as Paul Krugman explains, is where Europe's leverage comes from. It goes something like this: Not-so-nice banks you got here, be a shame if something even worse happened to them, if, you know, you don't do all the austerity we tell you to. It's an offer Greece hasn't been able to refuse, because if the ECB pulls the plug on the emergency lending its banks need, the only way Greece could keep its people from losing their money would be to print it. And the only way Greece could do that would be to leave the euro.

But it's an offer Syriza thinks it can refuse. It just doesn't believe the ECB would really kick them out of the euro and risk contagion in, say, Spain, where a one-year-old anti-austerity party has surged to the top of the polls. Markets, though, aren't so sure. That's why, as you can see above, Greece's banks started falling right after it became clear there would be early elections that Syriza would probably win, and started free-falling after Syriza did, in fact, do so. And why Greek depositors are pulling their money out of banks at a record pace right now. Better to get your money out now, while you'd still get euros, than to wait and maybe get drachmas that wouldn't be worth as much.

This is how the euro ends. Yes, with a bang, actually, and a bank run. This isn't how it was supposed to, though. It wasn't supposed to end at all. The euro, Barry Eichengreen argues, is irreversible, because even talking about leaving it would set off the "mother-of-all financial crises," stopping you from doing so. But what if, Krugman asks, you're already having the mother-of-all financial crises? Maybe it's because, even though you say you want to stay in the euro, markets think your policies will force you out of it. Well, then there's nothing keeping you in, because you're already on the way out. (Freedom's just another word for no banks left to lose). So what we might get here is a failure to communicate. Europe might say, look, you can't afford to leave the euro because your banks would collapse even more than they already have. And Greece might say, look, we can afford to leave the euro because our banks have already collapsed. In the worst case, this brinkmanship could get us what nobody wants: a euro that is very much reversible.

Saving Greece is a Herculean, but not a Sisyphean, task. Difficult, but doable. First, Europe should lower the interest rates and extend the maturities on Greece's debt. Then, it should give Greece more time to hit its budget targets, like France has given itself, as a way to discreetly divert austerity into a future that never comes. Taken together, this could cut Greece's surplus, before debt payments, from the 4.5 percent of GDP it's supposed to be down to, say, 2.5 percent. That wouldn't make a difference to Europe, since it still wouldn't have to put any more money in, but it would make a big one to Greece. Indeed, Krugman's back-of-the-envelope calculations show it could boost Greece's economy by something like 5.2 percent.

Europe could live with this, because Greece would at least be reciting the austerians' favorite chant. Specifically, Greece would be agreeing to play fiscal make-believe about paying the full face value of its debt, and not to renounce its austerity program. Still, Europe would need more than this. It would need Greece to cut more regulations if it's going to cut less spending. There should be no shortage of things to do, since Greece's markets are the reason the word "sclerotic" exists. It could mean going ahead with the privatizations it's stopped. Or turning the state's procurement system into something other than an excuse for graft. Or, as the new finance minister ambitiously put it, trying to "destroy the Greek oligarchy system." (As Alan Beattie points out, that's just as much a "structural reform" as making it easier to fire people). It just has to be something. That way, Europe can say it let Greece spend more because it's reforming more.

The point is that Europe should do whatever it takes to keep the Pandora's Box that is Grexit closed. You just never know what other portmanteaus might come out, like "Spanic." (That's short for Spanish panic). Real ugly stuff.

Matt O'Brien is a reporter for Wonkblog covering economic affairs. He was previously a senior associate editor at The Atlantic.