Greece and the cost of default

On what might be the eve of capital controls in Greece – bifurcating the unified currency zone – I want to bring some attention to an 2008 IMF paper and literature review of the costs of sovereign default. The most interesting result is… well, I’ll let the authors speak for themselves:

Perhaps the most robust and striking finding is that the effect of defaults is short lived, as we almost never can detect effects beyond one or two years.

Of course, the paper is richly caveated and many of the regressions performed include Latin American countries which occupy a different role in world trade and the international financial system than Greece, not the least the dual dynamics of default and Grexit that complicate any simple analysis, especially given the beyond monetary interest implicit creditors (i.e. the ECB) have in maintaining the Euro.

The authors, Borensztein and Panizza, identify four primary casualties of default: reputation, freedom to trade, the domestic banking system, and the incumbent government. These can be measured by credit rating or spread, trade balance, currency dynamics, and political upheaval respectively. Their conclusion points to an important pattern in historical defaults (including voluntary restructuring) – they were necessary and, more importantly, markets agreed.

Necessary in contrast to strategic – whereby the government elects to shortchange its financial creditors instead of its political creditors on the expectation that the former will be more forgiving than the latter (such as pensioners who vote). Part of the question might be what qualifies as strategic, and we’ll get to that. For now, the question of Greek default can be captured as:

The “default point” for a sovereign should be the point at which the cost of servicing debt in its full contractual terms is higher than the costs incurred from seeking a restructuring of those terms, when these costs are comprehensively measured.

Here is where the Syriza negotiating position becomes tenuous. If we define strategic default as any default that could be avoided by another negotiating party that could realistically realize general support from the electorate, it’s not clear the Varoufakis argument that Greece has made 75% of the compromise and creditors ought to yield on the rest is correct. With over two-thirds of the population favoring a deal over “rift with Europe”, and approval ratings falling by some 35 percentage points since April – Syriza seems to be overplaying its hand with respect to how much more Greek’s are willing to give up.

This conversation should be divorced from your moral calculus of Greek’s obligation – whether that be from the Left that Greek’s have realized more peacetime austerity, unemployment, and pain than any other nation and cannot reasonably give up more or whether it be from the Right that it’s incredulous Greece can pay out pensioners and maintain living standards well above some implicit creditors like Latvia where living standards are lower. The only thing that matters is the divergence between what the government will give up and what the people are willing to give up – and the people seem to be saying “make that deal now”.

Syriza is, of course, well aware of this and hence delaying default to the latest extent possible (in hope of extracting a deal without further concessions). As the IMF paper suggests, this is generally not a good thing:

High political costs have two important implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to “gambles for redemption” and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs. Delaying default might be costly for at least three reasons: (i) Non-credible restrictive fiscal policies are ineffective in avoiding default and lead to output contractions; (ii) Delayed defaults may prolong the climate of uncertainty and high interest rates and thus have a negative effect on investment and banks’ balance sheets; (iii) Delayed default may have direct harmful effects on the financial sector.

Many of the costs outline here seem to identify precisely the problem Greece is facing today – in extending its negotiation (gamble?) rather than defaulting. I’m an outsider. Maybe Varoufakis really thinks he can get his creditors to eat the rest of burden but it’s important to note here that this would still be default – at this point it really is only a question of partial versus complete default.

Europe really would want to accept this deal – partial capital loss would be much preferable to whatever restructuring Syriza would exact in the absence of a deal – but there is the natural concern of other peripheral countries asking for a similar deal. While I am more optimistic on Greece than some – like Larry Summers – I don’t fully share the confidence that most of the credibility problems would be gone in 2 years.

For one, let’s consider the third cost of default: freedom to trade. They divide this into two categories: (1) the emergence of retaliatory embargoes against defaulters and (2) the evaporation of trade credit necessary for importers to function. (1) is basically a theoretical concern at this point – something international macro papers use in their models but not a real or credible threat, especially with an EU country. (2), the authors find, doesn’t have a genuine long-run impact on existence of trade creditors.

I’d push back against this for Greece, and we don’t need to look further than 2012 to see why. In the first Euro crisis, trade credit insurers uniformly reduced their coverage of Greek debt on the risk that importers would still be obligated to repay their credit in Euros even when Greece gets on the drachma – and no one wants to be exposed to risk of external debt default. This is bad. Headlines such as “Greece Struggles To Keep The Lights On As Trade Credit Crunch Bites” weren’t figurative – energy exporters were no longer comfortable with Greek importers with the absence of trade credit insurance.

Therefore, unlike other countries which would default on their own currencies, Greece faces the legitimate struggle of feeding itself with baklava and olive oil – further escalating the political incentive to delay default.

You might reply that default need not imply Grexit and you might well be right, but that’s not the point. Default will with certainty bring about harsh capital controls on real and financial assets. A Euro in Greece will no longer be a real Euro and, unless importers have huge foreign balances with which to collateralize their purchases, the depreciation of the Greek Euro versus the Euro Euro will unleash similar dynamics on trade credit insurers as in 2011.

Unless, of course, investors have a credible schedule of when capital controls would be relaxed but if the government was in any position to give markets that relief it’s highly unlikely they would need capital controls in the first place.

But I’m less pessimistic than someone like Summers because my key reading of the IMF paper is that reputational costs remain small in the medium-term. If Greece defaults there’s no reason – after extensive depreciation of the drachma – why Greece couldn’t credibly commit to increasing revenues given the rapid external devaluation of its labor and obtain financing to scale those revenues and invest in, well, whatever.

I’m not as sanguine as Krugman, with his exception that he cannot think of “any examples that fit this story”. The trade credit disaster in 2011 is enough to provide one of an example of what might happen in a drachma world. And here economic recovery stands in one-to-one contrast with financial stability, i.e. to what extent can Greece dramatically undervalue the drachma.

If Greece defaults this will be the important dynamic it needs to figure out. One good bet might be to determine a drachma level that is sufficiently weak – but strong enough to finance highly price-inelastic imports such as energy inputs without entering into another fiscal death-spiral – and use its Eurosystem collateral (which would be expropriated in the event of default) to guarantee that level. By definition, there has to be an optimal level, and if Greece comes close enough to this, markets should have faith that it will defend against further devaluation. This would be a critical first step in reentering international debt markets.

There would be little margin of error here, as it works in the same sense that a one-time wealth tax “works” (as they are, in principle, the same thing). Further devaluation, or inflation that puts pressure on Greece’s FX reserves, could result in a currency crisis that is much harder to solve the second time around.

I’m not nearly an expert on the subject, but I imagine if the right thing happens, it will happen in the next 2 days. If and when Greece defaults and imposes capital controls it will always have been better, after the fact, for it to have happened before it actually did. Barclays noted that capital controls could provoke a political crisis bringing a moderate, Eurocrat party into power – “default without EA exit”, it wrote.

This might be necessary, if not sufficient, given the bargaining platform of Syriza – which seems to be leverage Europe’s commitment to the Euro and preference of partial over complete default to minimize its concessions – over a maximal commitment not to default. Krugman likes to denounce VSPs, but if default happens (as the IMF paper confirms) it is better it be supervised by a internationally credible party that would default only in the worst of circumstances.

Regardless who is in power, it will be prudent for the Greek government, if forced into default (i.e. involuntary restructuring), to offer a restructuring no worse than that to which it has already committed in negotiations – this may at least temper future market turmoil.

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