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Greeks choose the hard way out

Having decisively voted “no” or “oxi” in Sunday’s referendum, Greek voters are now down to two options:

▪ The Troika cravenly caves in the face of the mighty resolve of the Greek people and offers Greece very attractive terms for continued help.

▪ The Troika decides that they have had about enough of all this, and Greece exits the euro.

The latter seems far more likely than the former.

Greece’s problem is easy to state: austerity is horrible, a fixed exchange rate makes their economy uncompetitive, and the interaction of those two things promises a lot of misery for a long time. They want someone else to share some of their real and very deep pain.

The Troika’s problem is also fairly easy to state, in three words: Spain, Portugal, Italy.

These countries also have a bit of a debt problem, and the euro is not doing any favors for their economic competitiveness. They are much bigger than Greece. While a Greek default and exit from the euro probably won’t do much damage to the euro zone’s financial stability, a similar move from other PIIGS (Portugal, Ireland, Italy, Greece and Spain) would present a considerably larger problem. And if Greece gets a fantastic deal from its creditors, then the Troika is quite reasonably afraid that those countries are going to start asking why they’re the suckers.

There is a lot of missing the point in current commentary on Greece, a lot of ranting about private creditors who took haircuts years ago, and people citing the IMF to the effect that Greece’s debt is unsustainable and can’t reasonably ever be paid off. This latter point is true, but it’s been known for quite some time that Greece cannot actually pay off the money is owed.

Just looking at the mechanics of the IMF default and the pending payment they owe to the European Central Bank tell the tale: they need to come to a deal with creditors so that they will give them the money to pay the IMF, which will give them the money to pay the ECB, and so on down the road. We are not arguing about whether the Greeks should have to do austerity to repay creditors; we are arguing over how much austerity creditors will demand to continue to lend them money to roll over their unpayable debt.

Why do they need this control, you may ask? Why not just give them a clean haircut and let them rebuild as they will? Three reasons. Greece’s problem isn’t just its interest payments. It also needs money for ongoing spending. On the Econbrowser website, James Hamilton presents a fairly convincing case that Greece has never really had a substantial primary surplus; it has mostly been spending more than it collects in tax revenue, even if you get rid of the interest payments. But even if Greece had a small primary surplus a few weeks ago, it sure doesn’t now after a banking crisis. So if Greece exits the euro and defaults, the immediate result will be more austerity, not less.

The second reason that “lots of debt relief” isn’t the obvious answer is moral hazard: If default is too pleasant, we will get more of this. The Troika doesn’t want anymore of this. They think this is quite bad enough.

The Troika probably should have offered better terms years ago, with more debt forgiveness and less political control. Instead we’ve had endless renegotiations, which are costly and have created enormous bad blood between Greece and the rest of Europe. At this point we are hard up against some ugly politics on both sides, as well as a Greek economic crisis that will exacerbate these problems.

Which brings us to our third reason: politics. As Tyler Cowen wrote on the Marginal Revolution website, “A political program has to be something that voters could at least potentially believe, and international negotiations therefore cannot stray too far from common-sense morality, including when it comes to creditor-debtor relations.” I might add a corollary to this: You can actually stray quite far as long as voters aren’t paying attention. But once they are, you are going to end up back at boring old saws like “People should pay their debts” rather than advanced macroeconomic theorems. In a democracy, politicians are accountable to voters, however much you may deplore this as pandering to base and uneducated instincts. And German voters do not seem to want their government to give Greece a bunch of money with no strings attached.

So it’s hard to see how the creditors simply open the taps wide while substantially easing off on the austerity stuff. Which means it’s hard to see how Greece stays in the euro, barring some miraculous about-face from European politicians during the emergency summit they are planning to hold. Their banks are shut, people are sketching plans to make bank depositors take haircuts, and without more financial assistance from abroad, the government is going to default on another round of payments by the end of the month. The financial crises I have followed in other countries suggest that the natural next step is devaluation of the currency and restructuring of the banking system, which is to say, leaving the euro. But how, exactly, do they do this? Just the physical challenges of printing and distributing money is daunting. The other issues are harder still.

Normally, if you scrap your currency, you announce a new one for which the old can be swapped at some fixed rate. If you devalue, you announce that your old currency will now trade against dollars and Swiss francs at a new and less favorable exchange rate. But when that happens, the old currency or exchange rate goes away at the same time. In a Greek exit, you'll have two physical currencies circulating side by side: valuable euros versus drachmas of uncertain worth that no one, particularly your trading partners, will want. Which in turn will make it even harder to get the drachma up and running to the point that it functions as a reasonable substitute for the old euros.

I’m of the school that says Greece never should have joined the euro in the first place. But undoing a mistake is rarely as easy as not making it in the first place. The path out of the euro will be a lot harder than the path that would have led away from it 20 years ago. Nonetheless, that seems to be the path that Greek voters have chosen.

Megan McArdle is a Bloomberg View columnist who writes on economics, business and public policy.

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