Don't forget about Grexit

It is somewhat ironic that the phrase Brexit is heard far more frequently these days than Grexit, despite the fact that the latter was long viewed as the more likely event to happen. Although the Greek issue has not been anywhere near the top of investors’ agenda over the last eighteen months, the problems have not gone away. We were reminded of this recently when an IMF report was leaked to the Financial Times, which concluded that without relief, Greece faces an “explosive” surge in its debt burden which will raise the debt-to-GDP ratio from somewhere around 180% today to over 250% by 2060.

It is evident that the current policy mix is simply not working. Imposing more austerity on Greece in the hope that it will be able start repaying its debts anytime soon, is nothing more than delusional. Already the economy is suffering from what can only be described as a depression with economic output around 30% below levels recorded at the start of 2008. And the more output is depressed, the less likely it is that the economy will be able to generate the revenue to ease the fiscal situation. This is, of course, not news. Most economists see no way out of the debt trap into which Greece has sunk. But the EU continues to believe that more of the same medicine needs to be applied, which of course is nonsense.

Such is the IMF’s disquiet over the situation that there is a real threat it will not participate in the next round of the Greek bailout package, as it believes this is simply to throw good money after bad. But if it were not to participate this would put Germany in an awkward position because it has insisted on IMF participation, largely because it does not trust its fellow EU partners to sustain the pressure on Greece to reform. Moreover, with crucial elections scheduled this year in the Netherlands, France and Germany, the window of opportunity to agree the next stage of the bailout package appears to be closing without the IMF’s support.

We have been through this Greek tragedy on a number of occasions, with the fraught summers of 2012 and 2015 still very fresh in the memory. The good news is that at least the Greek economy is not contracting further and it is posting a primary surplus (i.e. excluding debt interest payments). But this has only been achieved at great cost to the economy and people of Greece, and it cannot be sustained on the multi-year horizon that the EU desires. There are some things that the Greek government could do, of course. For one thing, it could ensure that citizens pay the taxes which they owe, which amongst other things would involve a clampdown on the shadow economy which some academic estimates suggest equates to 25% of official GDP estimates – the highest in the EU. The IMF adds that Greece also needs pension reform and should impose a safety net to help those most affected by the recent crisis.

But this is in many ways to miss the point: All this should have been done years ago. Indeed, my own estimates, produced in a 2014 paper, reckoned that even if the government had taxed only 25% of shadow activity starting in 1999, this would have been sufficient to reduce the debt burden by 40% of GDP and would have put the economy in a much better starting point when the crisis finally struck.

However, we are where we are, and the issue now is where do we go from here? For the last five years I have advocated substantial debt relief. Without it, the problems Greece has faced will not only recur but they will get worse. It is questionable whether other EMU partners will allow such relief. But rather than writing off debt completely, as is often suggested, perhaps one thing that could be considered is the establishment of a sinking fund. This would allow Greece to transfer a substantial proportion of its debt to an off-balance sheet fund which has no designated repayment date. In this way, Greece can focus on the remaining debt (whether it be half, or two-thirds) and not have to worry about the rest. It can set aside modest amounts, as and when finances allow, in order that over a multi-decade (or even multi-century) horizon, the debt burden is gradually run down. After all, it is a strategy which worked for the UK in the eighteenth century.

Alas, few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB. But this would lay it open to the charge of monetary debt financing which is expressly prohibited by the Maastricht Treaty. Alternatively the IMF could step in, but given disquiet about its current role, that seems unlikely. But something must be done – and soon. If German public opinion further turns against granting aid to Greece, Grexit will once more become a reality.

Indeed, with Brexit now being set in motion, perhaps EMU members will be less willing to provide the support to maintain the integrity of monetary union than they were even two years ago. For all its tricky relationship with the EU, the UK is after all a net contributor to the budget and questions will be raised about why support is being provided to those which do not bring as much to the party. But if EMU countries wish to preserve their currency union, they will have to start thinking outside of the box or it will go the way of all such unions.