By: Declan Walker
In the past week, it appears that the realities of a Greek exit from the euro – Grexit – have diminished substantially, and a third bailout looks almost inevitable at this point, amidst current negotiations. Although continued austerity is certainly not what the majority of the Greek public wanted, a Grexit may have been just as – if not more – undesirable in the long run. Ultimately, neither a third bailout nor a Grexit are ideal for the Greek economy. The structural fallacies of the eurozone system (i.e. the impossibility of paying off austerity-induced debt absent of any monetary policy tool) is, among other factors, largely responsible for bringing Greece to its current position. However, the reality is that the past can not be undone, and this reality must be calculated into the cost-benefit analysis of determining whether Grexit would have been feasible. If current developments remain constant, and the terms of a third bailout are agreed upon, it would appear that the lesser of two evils will have prevailed.
The Austerity Effect on Greece: A Brief Analysis
At the heart of the Greek crisis is the issue of the austerity measures which were imposed on Greece by the Troika as a means to reduce the country’s fiscal deficit, relative to its GDP. These policies were carried out primarily via huge reductions in public expenditures and tax increases (a point where revenue from taxes exceeds government spending is known as a primary surplus), resulting in Greece’s already struggling economy to weaken even further. The major detrimental feature of Greek austerity, however, was a decrease in the price level – a phenomenon known as deflation. If one examines a simplified version of Irving Fisher’s theory of debt deflation, we see that the falling price level leads to an increase in the real interest rate; a rise in the real interest rate subsequently inflated the real value of Greece’s debt (not to mention reduced output and increased unemployment). Needless to say, running a primary surplus in combination with serious deflation has effectively seen Greece’s GDP shrink at a faster rate than the economy can reduce its debt. It is here we see the paradoxical and self-defeating outcome of the Troika’s proposed grand plan; The Greek debt-to-GDP ratio has increased from 126% in 2009, to its current level of 177%. It is highly unlikely that the proposed terms of the third bailout (a foreseeable outcome at this point) to be put forth by the IMF will ease the Greece’s toxic debt-to-GDP levels. Suffice it to say, claims that Greece might be better off to opt for a Grexit are not unwarranted.
Grexit and a Devalued Drachma
The economic rationalization of the Grexit route, in theoretical terms, is simple: by leaving the eurozone, Greece defaults on their debt burden and re-implements the drachma. No longer subject to the monetary rigidity of the EU, they devalue their currency substantially, Greek exports become cheaper, therefore promoting foreign investment, which then effectively offers the much needed stimulus to the economy (the tourism industry, in particular – which makes up roughly 10% of the Greek economy – stands to gain big in this regard). Proponents of Grexit argue that, while there will undoubtedly be some initial transitional turbulence in the short run, a devalued drachma will pay off in the long run.
However, the current situation is not that simple, and there are a number of crucial factors to assess before such a decision is made. First, one needs to consider basic macroeconomic principles: as the price of exports fall and their demand increases, the price of imports rise. This cost will be passed on to consumers, and as such, we see a rise in the price level – or inflation. Given the state of immense instability that the Greek economy is currently in (and inevitably would be, if the Grexit proved to be a reality), one has to seriously question whether or not the gains made from cheaper exports will be enough to offset the accompanying rise in inflation. Additionally, it is important to take into account the likely reactions of the rest of the European community. Given the hostility which has characterized the dealings between Greece and the other EU member states, it is reasonable to assume that the ECB will not be prepared to offer Greece the liquidity that would be needed to oversee a smooth transition from the euro to the drachma. These two factors (the ability to combat inflationary pressures and a very likely lack of ECB charity) are crucial to take into account when assessing the implications of Greece leaving the eurozone. Given the fact that there is now a high probability of a third bailout amidst negotiations, it is reasonable to maintain a sense of cautious optimism in assuming we will not be witnessing Grexit this summer.
What Should Be Done?
The reality is that Greece is forced into a losing situation regardless. With all political and economic developments taken into account, Greece staying within the euro and being held to the conditions of a third bailout and its accompanying austerity measures looks increasingly likely. A Grexit situation would undoubtedly be detrimental, but continued condemnation to the austerity purgatory Greece has resided in for the past six years is certainly no consolation to say the least. The most ideal situation – for the Greeks – would be if the IMF reduced their staunch demands for Greece to continue to run a primary surplus, and for the Troika to agree to pump liquidity into the Greek economy. It is important, in this regard, to recognize that the primary cyclical detriment is Greece’s egregious debt-to-GDP ratio, which, in order for any progress to be made in the debacle, must be reduced. Running a primary surplus will not remedy this, and unless avenues to immediately alleviate the debt pressure are pursued, then we will continue to witness the same ‘Greek Groundhog Day’ scenario which has persisted since the inception of the crisis.
Declan Walker is a graduate of the University of Toronto (’15), where he studied Political Science and Economics.