Greece is in urgent need of clear thinking. The only reason the country has not long since defaulted on its debts is that the European Central Bank continues to provide funds to the Greek central bank through its emergency liquidity assistance (ELA) scheme. The Greek central bank, in turn, lends money to the country’s commercial banks, which lend it to Greek citizens and foreign creditors. The problem is that both groups of borrowers have been transferring large sums of money to other countries.
The result is that overdraft credits to the Greek central bank have grown by nearly €1 billion a day in recent months. If Greece defaults and leaves the eurozone, these overdrafts will not be repaid.
ELA funding assumes that the Greek economy is temporarily illiquid, but not insolvent. This assumption is patently false. Despite all the pain Greece has suffered – a 30% drop in aggregate demand since the last cyclical peak and a rise in unemployment to more than 25% of the workforce – the Greek economy is still nowhere near competitive enough to repay its debts.
Part of the reason is that corruption remains high and administrative capacity to levy taxes remains woefully limited. Meanwhile, low-income Greek households have borne the brunt of austerity. In short, the mess continues.
But allowing Greece to default and still remain in the eurozone is not an option: it would signal that other eurozone countries could amass huge debts, funded by the ECB, without having any intention of repaying. Fiscal responsibility in the eurozone would be fatally undermined.
Yet forcing a defaulting Greece out of the eurozone – against its will – is not an option, either: it would plunge the country into economic, social, and political instability, and there would doubtless be serious repercussions beyond the country’s borders.
In my judgment, there are only two viable options left. The first – and more desirable – is for the ECB to assess realistically Greece’s lack of solvency and so stop providing ELA funds to its banking system. This would precipitate a payment crisis for Greece. But, recognizing the impending disaster, Greece would genuinely commit itself to the structural reforms that are in its own long-term interests: boosting the labor market’s flexibility, selling state-owned enterprises that most other European countries have already placed in private hands, and spending less on public-sector bureaucracy.
At the same time, Greece would ensure that these reforms do not hurt the poorest by introducing active labor-market policies (such as subsidies to train and hire the long-term unemployed). Furthermore, Greece would commit itself to an automatically implemented fiscal plan, specifying the long-run ratio of national debt to GDP, the convergence rate to this ratio, and the degree of fiscal counter-cyclicality.
So much for what Greece must do. In return, its creditors would agree to another one-time debt write-off – large enough to enable Greece realistically to repay its debts in the future, but small enough to avoid unnecessary transfers of credit. Greece would remain within the eurozone, having lost some of its fiscal and structural sovereignty.
If this first option is not taken – the likely outcome, given the current game of political brinkmanship – Greece will default. But that could set the stage for the second option, which I would call the “New Beginning Program.”
Under this program, creditor countries would write off Greece’s debts, on the condition that the country left the eurozone voluntarily. This would give Greece the opportunity to start afresh from outside the monetary union: it could restructure its economy without outside interference, and could be ready to re-enter the eurozone at a later point under new conditions – this time without false statistical pretenses or unrealistic expectations.
Such an option would allow the Greek government to make a new start in stimulating competition, fighting corruption, and otherwise building a basis for long-term growth. This would not be easy, but it would no longer be a process that Greece finds humiliating and creditor countries find exasperating.
This second option would be less desirable than the first. The speculative uncertainties associated with a “Grexit” might well threaten other eurozone economies (for example, Cyprus and Portugal), while Greece, with a devalued drachma, would find it painfully expensive to import the capital goods it needs to generate a broad base of high-wage jobs.
But the second option would also be a new beginning for the whole eurozone. Its member states would accept that monetary union is impossible without fiscal and structural coordination. The minimum fiscal coordination needed would involve automatically implemented national plans, formulated by each government in advance.
As a counterpart, structural coordination must, at a minimum, focus European Union funds on countries with long-term current-account deficits, the aim being to improve their competitiveness through investments in their human capital. Given that its current arrangements are neither credible nor sustainable, the eurozone needs this “new beginning,” regardless of which option Greece eventually takes.