Reforming Greek Reform

Greece’s new government, led by the anti-austerity Syriza party, presents the eurozone with a challenge that it has not yet had to face: dealing with national officials who are outside the traditional European mainstream. Syriza is in many ways a radical party, and its views on economic policy are often described as hard left; but the party’s take on debt and austerity is supported by many perfectly mainstream economists in Europe and America. So what sets Syriza apart?

All negotiations between debtors and creditors involve bluff and bluster to some extent. But Greece’s maverick finance minister, Yanis Varoufakis, has taken his case boldly to the media and the public in a way that leaves little doubt as to his willingness to play hard ball.

One might expect that the negotiations between the Greeks and the “troika” (the European Commission, the European Central Bank, and the International Monetary Fund) would be mainly about reaching an agreement about the economics of the situation. But that would be wishful thinking. The Germans, along with smaller creditor countries, are dead-set against any relaxation of austerity and are adamant that “structural reform” must remain a condition of further financing. They think that offering easier terms would be economically counterproductive, not least because it would give the Greeks an opportunity to go back to their bad old ways.

So what is unfolding before our eyes is not a rational discussion of economics but pure haggling. And just about the only bargaining chip that Varoufakis holds may be the implicit threat that Greece could leave the euro (“Grexit”). The threat is only implicit; most Greeks do not want Grexit, and Varoufakis and Prime Minister Alexis Tsipras have shied away of late from stating such intentions. But, without the threat, Varoufakis’s claims of democratic legitimacy would most likely fall on deaf ears in Berlin, Frankfurt, and Brussels. Syriza would have no choice but to continue the economic program it was elected to revoke.

The effectiveness of the Grexit threat depends on two conditions. First, Germany and other eurozone members must regard Grexit as a significant risk to themselves. Second, a return to the drachma must offer the prospect that the Greek economy will eventually do better on its own than in the currency union (and under the existing economic program). In the absence of the first condition, the eurozone will respond to Greece by saying, “Be our guest, leave.” In the absence of the second condition, Greece’s threat will not be credible.

And here is where economics re-enters the picture. Consider the first condition. Some observers seem to have convinced themselves that any Grexit spillovers would be manageable. Greece is both small and in a uniquely desperate position. So it is possible that other fragile members – Spain, Portugal, and Italy – would be spared from financial contagion and the euro’s viability would not be dramatically affected.

But the consequences are so unpredictable, and the costs of any domino effect potentially so large, that Germany and other creditors have no interest in precipitating a Grexit scenario. On the contrary, presiding over the eurozone’s breakup must be one of German Chancellor Angela Merkel’s worst nightmares. And if it is not, it should be.

The second condition, concerning the effects on the Greek economy, is tougher to sort out. Here, too, there are plenty of disaster scenarios. Grexit would require capital controls and financial isolation, at least for some time. The resulting uncertainty about policies and prices might produce a severe adverse shock on the real economy, sending unemployment to even greater heights.

But there are clear examples of positive economic outcomes resulting from breaking a similar currency bond. Britain dropped out of the Gold Standard early, in 1931, so that it could ease monetary conditions and reduce interest rates, and it did better than countries that delayed the exit until later. Argentina abandoned its fixed exchange rate against the US dollar in 2001, and experienced rapid recovery after two bad quarters.

In both cases, regaining monetary sovereignty allowed a more competitive currency, which in turn increased export demand and assisted economic recovery. Under Grexit, Greece’s best hope would be something similar – a sharp boost in external competitiveness. The Greek government has limited room for fiscal stimulus, and it would be shut out of financial markets. A cheaper currency could, in principle, reverse the effects of austerity.

Currency depreciation works by lowering domestic costs in foreign-currency terms. One such cost has already come down significantly in Greece. Since the onset of the crisis, Greek wages have dropped by more than 15% – a process called, appropriately enough, internal devaluation. Yet the response in terms of exports has been disappointing. Though the country’s whopping current-account deficit is gone, this reflects a collapse of imports – a result of austerity – rather than an export boom.

This fact on its own suggests that bringing back the drachma might not help Greece much. Greek exports appear to have been hampered by other factors. Higher energy costs (owing to increases in both excise taxes and electricity rates), credit bottlenecks, specialization in stagnant export markets, and generalized policy uncertainty all seem to have played a role. As a result, Greek export prices have not come down nearly as much as wages. Grexit might conceivably help with some of these costs, but it will aggravate others (such as policy uncertainty).

In the short to medium run, increasing Greek competitiveness requires remedies targeted at specific binding constraints faced by exporters. A Greek program that identifies these constraints and proposes remedies would be much better economics than blind adherence to the troika’s laundry list of structural reforms. It would also offer a credible alternative to remaining in the eurozone under current terms, thereby strengthening Greece’s hand in bargaining for a deal that ensures that Grexit does not in fact occur.

© Project Syndicate