Tsipras Making The Greek Tragedy Even More Tragic

Greece is in misery, and Alexis Tsipras is making it worse.

It is official now: Greece has formally defaulted on its $1.7 billion payment to the IMF. Historically speaking, Greece has neither been an exemplar of financial rectitude nor has it taken the sanctity of the debt contract seriously. In their landmark study, “This Time it is Different: Eight Centuries of Financial Folly”, economists Kenneth Rogoff and Carmen Reinhart wrote: “From 1800 to World War II, Greece found itself in continual default.”

Greece’s current woes have their origin in its fateful integration with the European Union (EU). As a member of the EU, Greece found itself awash with cheap credit, even as its institutional maturity and reporting practices were more like that of a fragile developing economy. Troubles began in 2009 when then Prime Minister George Papandreou admitted that the Greek fiscal deficit figures were bogus and hugely underestimated the extent of the deficit, presumably to comply with EU norms (the Maastricht treaty set a fiscal deficit-GDP ratio of less than 3 per cent as the desired benchmark). When recalculated as per more exacting Eurostat standards, the deficit was found to be unacceptably high at 12.4 per cent.

Following the discovery of creative accounting practices, private credit flows stopped and the Greek economy was put on the ventilator, kept alive by credit transfusions from the European Central Bank (ECB), IMF and the European Commission (the so-called troika). Greece was technically in default in 2012 and once again the troika bailed it out by restructuring its loan commitments.

For a brief period starting from 2014, green shoots of recovery were visible as the growth rate was positive in three successive quarters. More importantly, a small primary budget surplus was eked out. It almost appeared that Greece will finally manage to grow out of its debt. However the snap parliamentary elections held in January 2015, which brought Syriza, an anti-bailout party with strong left credentials to power, proved to be a turning point. In the last few months since then, the hard-won primary surplus has evaporated, growth is in negative territory, the government has walked out of talks with creditors, asked for a referendum, brought in capital controls and declared a bank holiday.

Without creditors’ support and continued injection of fresh credit, Greece’s exit from the Eurozone is almost certain. With its junk grade credit rating, private credit is simply unavailable; only credit flowing from official channels is keeping Greece afloat. After default clauses are triggered, even those credit lines and facilities will go away (unless there is fresh re-negotiation). Additionally, Greece will have to deal with massive capital outflows. Yes, capital controls have been imposed. But there are ways around these controls, for example by over-invoicing imports and under-invoicing exports. Distinguishing between trade-related transactions (which are legitimate and vital) and capital account related transactions (which are prohibited) is never easy. Greece is a country with porous borders where movement of goods and people is unrestricted. In such a country, capital controls are notoriously difficult to implement.

The Greek economy would need to increase its current account surplus to ‘finance’ every euro of capital outflows. This requirement will precipitate a Balance of Payment (BoP) crisis. Typically there are two ways of handling BoP crisis. A country may depreciate its currency, ‘switch’ domestic expenditure away from foreign markets and generate sufficient BoP surplus (‘expenditure switching policies’ in economic jargon). As long as Greece doesn’t have its own currency it can not pursue expenditure switching policies. Only remaining option is to reduce aggregate expenditure by social security cuts etc. With unemployment rate already exceeding 27%, it is unlikely that so much of expenditure compression can be achieved without serious social dislocation.

For these reasons, many economists, including Paul Krugman, are advocating a new domestic currency. The trouble with this idea is that there is a world of difference between simply letting an already overvalued currency depreciate and starting a new currency when the very credibility of the national government is in serious jeopardy. What will be the worth of a Greek IOU just after the treasury has made a sovereign default and is reeling under severe financial crisis? Obviously, the new currency will be hugely undervalued. But the big question is just how much? What if people refuse to accept the new currency at any price point? When a government lacks credibility, the value of the currency it prints lacks a lower bound (i.e. can be anything).

In extreme scenarios, the prospects of a Zimbabwe type hyperinflation cannot be ruled out. Even in relatively benign scenarios, the Greek economy will have to suffer a prolonged period of stagflation. Following a default, it will be decades before external credit resumes. There will be a run on the banks (which has already started). Most depository institutions will go bankrupt, choking not only lending and investment cycles, but also payment conduits. The picture is certainly not pretty.

Irrespective of which path Greece should follow (and answers are not obvious, there are arguments both ways), there is little doubt that Prime Minister Alexis Tsipras is writing a manual on how not to deal with a financial crisis. If indeed he believes that walking out of euro is in national interest, as the head of elected government, it is his prerogative (and mandate) to take that decision, build political consensus, minimize uncertainty and prepare the road-map towards resurrecting drachma.

Instead, in the middle of the discussion, he seems to have washed his hands off this mess. Deflecting the decision, he has asked for a simplistic yes/no referendum on a highly complex topic. Just when political consensus was the need of the hour, he has further polarized political environment by building a bizarre coalition consisting of far-left and neo-nazi parties to vote out pragmatic centre-left and centre-right parties in the parliament.

Tsipras’s rhetoric is not helping matters either. Sample some of his tweets:

https://twitter.com/tsipras_eu/status/614930010646949888

and,

https://twitter.com/tsipras_eu/status/614941442646130688

It sounds as if he is asking for fresh installments of loans almost as a matter of right! Not only is his sense of entitlement baffling but he also seems unable to understand just how precarious his position is.

Besides the logistical difficulties involved in holding a referendum at such a short notice, few know what the legal standing of the referendum will be, as the creditors’ legal offer technically expired on June 30. The political implications of the referendum are graver still. Should the voters now accept the creditors’ offer— as many surveys are predicting— Tsipras’s credibility as a negotiator will be finished. He will have no option save submitting his resignation. The only way of ending a political gridlock will be fresh elections.

In a full-blown financial crisis, last thing one wants is a mix of political and constitutional crisis. Thanks to Tsipras’s antics, increasingly that is the direction Greece seems headed towards.