In strategic games, threat points determine the outcome. In the negotiations between Greece and its creditors, the threat point was always Grexit. The Greeks could walk out, leaving a hefty bill behind. The creditors could cut the flow of cash. But, of course, threat points must be credible, and the Greeks were not ready for Grexit.
No drachma banknotes were printed, no coins were minted, no bank algorithms were readied and, crucially, no legislation was ready for the redenomination of contracts. On the other side, Herr Schäuble had long indicated that Grexit was his preferred option and the Chancellor started to talk of humanitarian assistance. The President of the Commission boldly stated that ring-fencing plans had been worked out. By suspending fresh liquidity assistance, and thus forcing the closure of banks, the ECB gave the Greeks a taste of what Grexit could mean.
The only question was whether the creditors were willing to resort to such an aggressive move. The ferocity of the conditions imposed on Greece has shown that they are, and more.
What happens next?
The Greek Prime Minister, Alexis Tsipras, has clearly indicated that he does not believe that these conditions will bring anything good to his country so, one way or another, Greece will not deliver. The creditors are determined to impose their conditions. A new showdown is unavoidable. If he does not want to face another humiliating defeat, Tsipras should start preparing.
There is a sea of difference between a panicked exit and a carefully prepared and managed breakup.
- Based on the experience of Argentina in 2001, Grexit stands to be a disaster (Levy-Yeyati 2012), Cavallo 2015).
- Based on the breakup of Czechoslovakia, it may not be so.
Preparation will make the difference. Exiting the Eurozone is considerably more complicated than a devaluation, and many things have to be done to reap the benefits of the regime change.
Shopping list for exit preparation
The obvious is to prepare the plumbing. Print banknotes and produce coins that will be accepted in vending machines, preposition them throughout the country and draft the legislation that will define the new legal tender and the transition between the euro and the drachma. Banks will also need to prepare. This is a conceptually simple task and one that was performed a decade ago in the opposite direction, so the know-how exists. Yet, it requires months to be completed. In that sense, this is an urgent task.
Make depreciation work
More challenging are the preconditions to make the new regime successful. When the Argentinean peso was severed from the US dollar, it promptly lost nearly half of its value, which triggered high inflation, a huge tax on the poorer segments of society. This does not have to be, although a depreciation would greatly help.
We know from Eichengreen and Sachs (1985) that the time at which countries escaped from the Great Depression was largely determined by the speed at which they left the Gold Exchange Standard. Recovering exchange rate flexibility stands to create a crucial precondition for economic recovery, but that will not be enough. The economy must be ready to benefit from the move. This requires three preliminary steps:
- Prevent the all too familiar depreciation-inflation vicious cycle.
The Central Bank of Greece must be given a clear mandate with full independence to act accordingly. Inflation targeting is the current state of the art and independence conditions are well established. The central bank’s officials must be able to navigate troubled waters with a mixture of determination and flexibility. The old boy’s network will definitely not do.
The British model of a Monetary Policy Committee (MPC) that includes internal bureaucrats of impeccable competence and external members with superb analytical skills stands to be the right model. There are enough solid Greek monetary economists in Greece and abroad to build up a first-class MPC. They need to start working immediately to define a strategy and map out how it can be implemented.
- Create conditions for devaluation to be effective.
It is understood that the goods markets are not functioning properly and that this has long stunted the ability of Greece to be a competitive exporter in whatever industries its comparative advantage lies. Many studies have indicated what has to be done (Papaioannou et al. 2015) and in what order (Campos and Coricelli 2015).
A number of promising reforms are in the list of conditions imposed by the creditors. The Greek government would do itself a favour to implement the reforms that matter – thus giving itself some leeway vis-à-vis its creditors – in the right order while ignoring the silly ones like Sunday store openings or the fire sale of state assets. Having these reforms humming by the time of Grexit will make all the difference between success and failure.
- The new exchange rate regime must be compatible with EU membership.
The treaties require member countries without a derogation to eventually join the Eurozone. A large number of countries that are able to join the Eurozone (e.g. the Czech Republic, Hungary, Poland and Sweden) happily fail to comply without facing any wrath from the rest of the EU. Greece must develop its strategy to join their ranks.
Banks will have to be resolved promptly, if possible at no cost to taxpayers. The Bank Recovery and Resolution Directive (BRRD) is the state of the art. Shamefully, it has not yet been written into Greek law. That is easy, it is on the shelf. Also needed is a draft protocol between the central bank and the treasury. The central bank will have to put up the cash but potential losses must be guaranteed by the Treasury.
Debt and fiscal discipline
In order to not depend on official lending, and the attached conditions, Greece must recover market access and, ever after, to uphold fiscal discipline. Several steps are required:
- Quite obviously, Greece will have to default, but carefully so.
Along with a depreciation, this is a necessary condition for recovery. Debt to the IMF must be serviced because one may always need the IMF, if only for technical assistance. Debts to the private sector should not be defaulted upon, if only because much of it this is owned by Greek financial institutions; it makes no sense to write these debts off and then to borrow to recapitalise banks. For the rest, the debt is owed to various European institutions and governments. This will have to be fully written off. This is the easy part.
The harder part will be to reach an agreement. As is well known (Levy-Yeyati and Panizza 2011), creditors always start from the position that they are incensed and will recover their lost monies. Over time however, and not much time either, they come to recognise that bygones are bygones and negotiation becomes possible. Greece must ready itself for these eventual negotiations. Brady bonds are an example, others exist.
- Borrowing from markets is optimal in bad times but cannot be a way of living.
Eurozone membership or not, the budget constraint is not a choice but an obligation. Hopefully, Greece has learned not to trust bankers and other investors who smile and lend irresponsibly in good times, only to walk away and seek protection from their authorities in bad times. Many countries have adopted solid frameworks that combine a simple rule with some discretion in the hands of an independent council (Wyplosz 2011). Slovakia and the UK provide good blueprints and lessons must be learned from the Hungarian debacle (Kopits, 2012).
Preparing the country for a successful Grexit is a tall order. It calls for skills that are unlikely to be in ample supply in Greece today. It is also a task that must start immediately and that must progress at an unusually fast pace. It cannot be a trial and error process.
The Greek government needs advice from top-quality, experienced people. Many of the best ones are in the IMF, but that may be too sensitive politically. The Greeks could, however, tap into the considerable knowledge of the large group of former IMF staff members who are still eager to serve. Many of them are unhappy with the Fund’s performance. Another resource is former officials from countries that went through similar experiments, as well as the small army of superb academic Greek economists. The government should avoid the familiar trap of asking help from banks and consulting firms, which have ulterior institutional objectives, including commercial ones.
The Greek administration is notoriously ill adapted to carry out reforms for a number of untold reasons that include corruption, corporatism, nepotism and incompetence. The best thought-through decisions will remain theoretical unless they filter down the administration to be implemented as intended. It takes years to fix a malfunctioning administration. International organisations like the OECD and the World Bank can provide technical assistance, but this will be too slow. Greece should accept that it needs to bring foreign experts in, on a temporary basis. These experts should work with newly hired, young, talented Greeks selected on the basis of merit, not family connections.
Si vis pacem, para bellum
It should be clear that Grexit remains a disastrous choice, but it has become the default option for both Greece and its creditors. Preparing for Grexit does not mean leaving the Eurozone. Paradoxically perhaps, a credible threat point may deliver a better outcome for both Greece and its creditors. The purpose of the exercise should be to make Grexit a plausible solution, then not to do it.
Campos, N. F. and F. Coricelli (2015), “Reforming Greece”, VoxEU,17 July.
Cavallo, D. (2015), “Looking at Greece in the Argentinean mirror”, Vox EU, 15 July.
Eichengreen, B. (2010), “The Breakup of the Euro Area”, in A. Alesina and F. Giavazzi (eds.) Europe and the Euro, The University of Chicago Press: 11-51.
Eichengreen, B. and J. Sachs (1985), “Exchange Rates and Economic Recovery in the 1930s”, Journal of Economic History XLV(4): 925-946.
Kopits, G. (2012), “Can fiscal sovereignty be reconciled with fiscal discipline?”, Acta Oeconomia 62(2): 141-160.
Levy-Yeyati, E. (2011), "How Argentina left its Eurozone", VoxEU, 2 October.
Levy-Yeyati, E. and U. Panizza (2011), “The Elusive Costs of Sovereign Defaults”, Journal of Development Economics 94(1): 95-105.
Mody, A. (2013), “Sovereign Debt and its Restructuring Framework in the Euro area”, Working Paper 05, BRUEGEL.
Papaioannou, E., R. Portes and L. Reichlin (2015), “Greece: Seeking a way forward”, VoxEU, 19 June.
Reinhart, C. (2015), “Lessons for Greece: Forcible currency conversions from 1982 to 2015”, VoxEU, 09 July.
Reinhart, C. and C. Trebesch (2014), “Sovereign-debt relief and its aftermath: The 1930s, the 1990s, the future?”, VoxEU, 21 October.
Wyplosz, C. (2011) “Fiscal Discipline: Rules Rather than Institutions”, National Institute Economic Review 217, R19-R30.
 Eichengreen (2010) draws the parallels and differences between the breakup of Czechoslovakia and the situation in the Eurozone.
 Reinhart and Trebesch (2014) remind us of how, historically, default have been followed by recovery. Reinhart (2015) reminds us that authorities always far too long and presents the challenges of successful debt write-downs.
 A recent review of options is in Mody (2013).