Holding Out for a Euro

In Friday's Paul Krugman column, gloom about Greece:

Greece’s problems are deeper than Europe’s leaders are willing to acknowledge, even now — and they’re shared, to a lesser degree, by other European countries. Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

Barry Eichengreen is a relative optimist, but even his roadmap out of the crisis begins with a debt restructuring:

European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.

First the easy part: Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package.

Only the delusional can believe that, when everyone else is taking swingeing cuts, Greece's creditors can continue receiving 100 cents on the euro. It beggars belief that Greek government debt can top out at 150% of GDP, as the IMF envisages. At this point the government will be transferring well more than 10% of national income to the creditors. In a time of severe austerity, this outcome is unsustainable both economically and politically.

The lack of a restructuring seems the most obvious weakness of the current rescue plan; on this The Economist makes an astute point:

EU governments and the IMF refuse to discuss the possibility of an eventual rescheduling of Greek debt for fear that it would spark uncontrolled contagion. In fact, the logic may increasingly be the opposite. By refusing to admit that Greece faces an obvious solvency problem, whereas Spain, Portugal and Ireland do not, Europe’s policymakers have made it harder to draw a clear distinction between Greece and the rest. As a result contagion has intensified.

Why is the Greek government so hesitant to make a move that seems so obviously necessary? In a Vox column, Edwardo Borzenstein and Ugo Panizza offer a political economy insight from their research:

[D]efault episodes seem to have high political costs. We find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support. We also look at changes in top economic officials and show that in any given tranquil year there is a 19% probability of observing a change in the finance minister, but after a default episode the probability jumps to 26%. The presence of such political costs has two 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.

Krugman's column also prompted an interesting exchange on optimum currency areas - the crisis shows that Europe isn't one, but how sure are we that the US is? - among Greg Mankiw, David Beckworth, and Krugman.

On Greece, see also Ezra Klein's conversation with Desmond Lachman and this Vox column with advice from Domingo Cavallo (!!*), which includes an interesting idea about how Greece (and Portugal and Spain) could improve competitiveness without devaluation by shifting taxes from labor to consumption.

*Argentina's Finance Minister during its 2001 crisis.