Blanchard and Delong on the Greek endgame - and implications for Spain and the future of the Euro

After the crisis is before the crisis... Olivier Blanchard (via Brad Delong) has some simple home truths for those who think that Greece has now been "rescued" by cutting its privately-held debt by ~80%, a uniquely savage restructuring for any country except Ecuador and Argentina -- what great company for the Eurozone. It's really a gentle reminder that Merkel, Schäuble, and the rest of the German "Austerity Will Solve Everything" Muppet Show just failed Econ 101. The real underlying issue, as Blanchard points out, is the continued current account deficit - still 10% of GDP. Olivier points out that leaving the Eurozone would give Greece a chance to finally increase competitiveness, but with his IMF hat, seemingly rules this out as impractical. Brad Delong, probably remembering the experience of leaving the gold standard in the 1930s, strikes a different balance -- with quitting the Eurozone looking much better. And everything that we say about Greece also applies to Spain. Here is why "internal devaluation" (ie savage wage cuts), the only alternative route to make countries competitive, will never work in the Club Med:

• strong unions combined with an inclination to strike and raise hell. That will damage growth directly
• high private debt burdens. The average Spanish family carries so much debt thanks to consumer + mortgage lending that even a 10% wage cut translates into a 30% fall in disposable household income
• small export sector -- after years of post-industrial growth, there isn't enough of a manufacturing sector left that could benefit from a major increase in competitiveness

So, overall, I think Brad is right - for many countries in the South of Europe, the costs of staying in the Eurozone far outweigh the benefits. Responsible governments should prepare for the day after.

Beware of the people who cite you...

for the wrong reasons. Over at the Daily Telegraph, Ambrose Evans-Pritchard had lunch with Carmen Reinhart, who (together with Ken Rogoff) wrote a well-timed, erudite and enormously important book on financial crises: This Time Is Different. Evans-Pritchard cites my work with Mauricio Drelichman on the debts and defaults of Philip II. He argues that Greece is a bit like Habsburg Spain -- and that default is inevitable. I actually agree with the conclusion, but I cannot agree with his characterization of why bankers lent to Castilian Crown. Mauricio and I basically say -- the defaults were anticipated; bankers made money, on average; and a default was simply a bad outcome that everyone anticipated could happen. Much like in the case of insurance, the insurer sometimes has to pay out. In good times, they collected a lot of money upfront. It all evens out.

Somewhat oddly, Evans-Pritchard drags out the old chestnut how Philip II's defaults ruined his bankers, including the Fuggers. This is what Fernand Braudel famously claimed, but we find the exact opposite -- the same banking familes who lent to Charles V also lent to Philip, and the ones affected by the early bankrutpcies (in the 1550s) are still there in the 1590s, doing a healthy business, including the Fuggers. Even a default needn't be a calamity, if you play it right.

The implications for today? I think a Uruguayan solution (ie a healthy haircut for the bondholders) would make a lot of sense. It won't be fun for the investors, but we are creating a world of monstrous moral hazard if we bail out Greece and, in turn, the French and German banks who bet that the taxpayer will always help. Will this create another Lehman-style meltdown? I don't think so. Financing costs on sovereign debt are going to go up anyway, by a bit, in the next few years; many people are worried about the overall level of debt as it is. A Greek default won't change a thing. A lot of people received higher interest on their Greek bonds (unless they bought in the last 2 years); the higher return goes with higher risk, which should materialize in their portfolios roundabout now.

Moving on...

It's always nice to hear from our former students, and all the more so when they are doing well. Juan Montecino, who attended the ITFD master as part of our inaugural year 2008-09, just dropped me a line from Washington, DC, where he is working for Center for Economic and Policy Research for a think tank called the Center for Economic and Policy Research. He is covering international economic developments, with a special eye on IMF policy and Latin America. Recently, he put his skills to use in the policy paper IMF-Supported Macroeconomic Policies and the World Recession: A Look at Forty-One Borrowing Countries. We hope to see more policy research from Juan in the future!