Can Greece Keep the Euro and End Austerity? Perhaps So!

I've been trying to read and to listen carefully to what the Greek government has been writing and saying. This Greek government's public representations have so far matched its actions, so it's particularly important to listen.

Today, Greece's Foreign Minister, Nikos Kotzias, reportedly told China's Ambassador to Greece that Greece is not leaving the euro zone. (The press report used "euro zone" instead of "Eurozone.") Is that possible? It might be.

The key to understanding how a sovereign default could work within the euro, at least in theory, is that there are important, critical differences between the Eurozone (including European Central Bank support and the Eurosystem) and maintaining the euro as legal tender. There are two countries that adopted the euro as their medium of exchange without any monetary agreement or other coordination with the Eurozone: Montenegro and Kosovo. Their entire economies operate on the euro. In principle Greece could do the same. The Bank of Greece could legally maintain its Eurozone membership but, with an uncooperative European Central Bank, de facto operate as Montenegro and Kosovo do.

OK, without commenting on whether that outcome is desirable, is it possible? Probably. Even assuming an ECB that doesn't return the Bank of Greece's phone calls, there's no available mechanism for the ECB to prevent Greeks from using euro. Indeed, efforts to prevent the free exchange of euro would undermine the euro's status as global, convertible currency. Such efforts would also harm Montenegro and Kosovo.

The Bank of Greece has already adopted capital controls including withdrawal limits of 60 euro per day per depositor. A significant fraction of the Greek economy, perhaps a third, is already operating "in the black" and off the books, primarily on a euro cash and barter basis. Austerity-fueled and ECB-supported "bank jogs" have already done great damage to the Greek economy and its financial system. The Bank of Greece could, in principle, maintain capital controls and (probably) nationalize what's left of Greek banks. Moreover, there's no particular reason why Greeks in Greece need to have bank accounts in Greece, and many have already established accounts elsewhere in Europe.

The Greek government is already running a primary surplus, meaning that tax revenues (even with significant compliance problems) are supporting government services and benefits. When (not if) the Greek government defaults on its external debt it'll have more euro to keep. The Greek government won't be able to borrow more, but that's already true.

Could that be the plan, to tell the troika "piss off," run the Greek government on a neutral domestic cashflow basis (better than sending the surplus to the troika), and remain within the euro zone (lowercase) de facto, just as Kosovo and Montenegro do? It could be. Moreover, Greece could be on firm legal footing in doing all that. The troika and the ECB, on the other hand, might have several legal problems (at least) if they try to act maliciously. It's one thing to suspend support but quite another to go to war (metaphorically one hopes) against one of its members. They may be very, very angry, as foolish creditors often are, but I don't see how they legally retaliate against a sovereign in their midst.

Greece: What's Really Happening, What Matters

If you'd like to understand what's happening with Greece and its economic situation, here's a quick guide.

1. Before the 2008 Financial Crisis, Greece borrowed too much and European banks lent too much. This credit overextension problem was the direct result of a poorly designed Eurozone, a monetary union without fiscal union.

2. Government institutions bailed out the overextended banks, assuming the bad Greek (and many other bad) debts. That bailout was not handled particularly well.

3. Just as there was no way the banks could sustain those bad debts (hence the bailouts), equally there is no plausible (or even implausible) way the Greek government can repay all of its debts. Yet the government institutions substantially have not (and continue to refuse) to write off Greece's debts.

4. Greece's governments have tried to service that debt held by public institutions (and all other debt), but in the process the government created great misery and horrific economic depression in Greece. This set of self-defeating policies is called "austerity." Greek unemployment is now about 26% and Greek GDP fell by about the same percentage. Greater poverty and immiseration means it's even more impossible to pay off euro debt.

5. A new Greek government came to power on a promise to end austerity. That government negotiated with its external creditors (government institutions, i.e. the "troika") for months and failed to reach an agreement that included debt relief -- or indeed any material changes to the existing, counter-productive austerity policies. The troika offered more of the same: never-ending economic depression in Greece.

6. The Greek government refused more of the same and now seeks a public referendum backing its refusal. The Greek government will presumably stop servicing its external debt and will default on that debt. (As it should have done years ago in a negotiated but still deliberate way.) That's the only decision the Greek government can make, and it's a good one. Or at least it's the only realistic one. The math doesn't lie. There's just no way the debt is repayable. (Importantly it appears that the Greek government can and will continue servicing internally held debt, particularly the debt held by its domestic banks. It just isn't going to continue playing a mathematically impossible charade with the IMF, in particular.) On June 30 the Greek government owes $1.6 billion to the IMF, and the Greek government does not plan to make this payment. That's "default."

7. The European Central Bank (Mario Draghi, really) now has a decision to make. Will the ECB destroy the euro-based Greek banking system simply because another entity, the Greek government, is defaulting on its external debt? In the language of central bankers, will the ECB decide that Greek banks are facing a solvency problem instead of a liquidity problem because the IMF isn't getting paid? It's the ECB's decision to make, and it's a very strange one indeed, a decision Draghi has desperately wanted to avoid having to make. Central banks aren't usually in the habit of destroying their own banking systems, even partly. There are no precise analogies here, but this would be a bit like the U.S. Federal Reserve deciding to torpedo Alabama's banks if the Alabama state government stopped paying its bonds held by Wisconsin. Yet that's the "logic" of the Eurozone.

8. Of course the Greek government must prepare for the possibility the ECB will act to destroy Greece's banking system. The Bank of Greece (Greece's central bank) will bear most of the responsibility to protect and defend Greece's banking system. If the ECB does terminate Greek banks' access to Emergency Liquidity Assistance (ELA) then the Bank of Greece will likely have to respond in these three basic ways:

(a) Declare a bank holiday (that could last several days), keeping the banks closed;

(b) Introduce capital controls, meaning limits on withdrawals (particularly internationally);

(c) Possibly introduce a new currency, most probably a purely electronic one that operates via debit cards and smartphones.

Cyprus has recent experience with (a) and (b). There may also be another option:

(d) Request and obtain a loan from Russia to help keep Greece's banks capitalized. (The Russians have offered in part for geopolitical reasons.)

The Bank of Greece will probably also have to nationalize the banks, meaning to take equity (probably all of it) in those banks. That's a minor detail in terms of execution, but it's an important one for public governance.

9. If the ECB acts to destroy the Greek banking system, and the Bank of Greece is forced to respond to protect and defend Greece's banking system, there will be disruption and turmoil, and not only in Greece. However, with the key assumption that the Greek government and the Bank of Greece execute well -- the Greek government does have many smart people, fortunately -- the disruption will be relatively short lived. There are several countries that have followed this path, and they've recovered nicely. Iceland is arguably a useful, recent example, though Iceland always had its own currency and never joined the euro.

10. Greece will remain within the European Union and Schengen Area unless other European governments do something particularly stupid and perhaps even illegal. True, European policymakers have often acted stupidly in recent years, but I would not bet heavily on this particular form of stupidity on this occasion. Note that Norway and Iceland do perfectly well outside the European Union as members of the European Economic Area (EEA) with their own currencies, so Greece does not actually require EU membership to restore economic growth and prosperity. The only real advantage to EU v. EEA membership is the ability to influence policy within the EU, but since Greece hasn't been able to do that anyway, it doesn't matter.

11. In the hopefully unlikely event EU governments continue to act stupidly with respect to Greece's membership, EU leaders should bear in mind that Greece is housing many thousands of asylum seekers and refugees. There are costs to continuing policy stupidity.

12. EU policy leaders talk as if they are confident Greece's issues will not "blow back" to cause turmoil in the rest of the Eurozone. I wish I were so confident. The financial markets have shown a strong ability to sense "blood in the water" and attack, shark-like, the weak and the vulnerable. European public institutions will likely discover that this botched exercise is even more expensive than a negotiated, managed write-down and Greek economic recovery plan would have been. One of the ways Greece will be "expensive" is in Spain where that government is more likely to fall at the next election. One of the ways European leaders have been particularly out of touch and particularly stupid is in their tolerance (or obliviousness) to the pain and suffering of the unemployed amidst persistent economic depression. It's a human emergency, and the EU's inability to solve that emergency is its greatest, overarching failing.

In Praise of the Greek Government

I wrote about Greece's economic situation earlier this year. A few points:

1. Greece's government is acting reasonably, logically, sensibly. (See the Greek Finance Minister's latest verbatim statement, for example.) Unfortunately Greece is dealing with European ministers that are not. They're not even acting like good (or even average) bankers would.

2. To reiterate, the European Central Bank could act to destroy what's left of Greece's euro-based banking system or not, but make no mistake that it's the ECB that will be at fault if it does so. Blame where blame is due.

3. To reiterate, if the ECB destroys what's left of the Greek banking system then Greece's new currency (after a bank holiday) will be entirely electronic, primarily based on debit cards and smartphones. Greece will become Europe's first truly cashless society, and (ironically) the euro will become Greece's black market currency (in a hopefully shrinking black market). The Greek government won't even bother to mint new coins and print new bills. The transition will be tumultuous, of course, but after the dust settles it'll work quite well. Tax evasion and undeclared labor will become harder to pull off since all Greek currency transactions will be electronically recorded. The Greek government has some smart people who will make this work.

4. Greece will remain in the Schengen Area and in the European Union unless European governments somehow act in concert (and with unprecedented malice) to expel Greece. Blame where blame is due again. That'd be completely dumb from the point of view of Europe's self interest (and the European public interest), but see #1 above.