Forbidden Conversations – Greek Withdrawal or Default

By Andrew Brons MEP. In many societies, certain conclusions about certain subjects are, at best, frowned upon or, at worst, forbidden by law.  I shall avoid discussing or even mentioning conclusions that are forbidden by law, for fear of being thrown forever into some dank and dark dungeon in a remote corner of the Union. I shall restrict myself to areas of international finance in which some discussions are simply discouraged.

Angela Merkel, the German Chancellor, recently expressed her disapproval of any colleague who might speculate on the possibility of a Greek withdrawal from the Euro and/or default on its debt.

 That a German Chancellor should consider it appropriate to seek restriction on the expression of certain opinions should not surprise us. Restrictions on thought and expression are etched deeply in the modern German political culture, quite as much as they were in a somewhat earlier political culture.

However, there is some rationality in her repressive instincts on this issue. Fear of Greek default and exit from the Euro would encourage those holding Greek sovereign debt to sell it, forcing the market price downwards. Its downward momentum would add further speculation about imminent default and would force the Greek Government to put a higher ‘coupon’ (or nominal face value return) on Greek bonds subsequently issued and it would make them especially difficult to sell. Short of further assistance from the IMF/EU, this would necessitate greater intervention by the European Central Bank and others to buy Greek sovereign debt, in order to  raise the market price of Greek Government bonds. Fear and expectation of Greek default would thus ha ve an ‘oedipal effect’ of bringing it about.

This would necessitate greater intervention by the European Central Bank and other to buy up Greek sovereign debt on the markets, in order to raise the market price of Greek Government bonds. Fear and expectation of Greek default would thus have an ‘oedipal effect’ of bringing it about.

The episode reminds me of the first administration of Harold Wilson (1964-70). Wilson forbade even mention of the word devaluation at Cabinet meetings, lest any report of such discussion should bring about the very measure that they were seeking to avoid. Rumours of an intention to devalue would have led speculators to sell sterling, which would have pushed the ‘natural’ price of sterling downwards.

Sterling was then pegged at $2.80 but it was pegged by intervention in the market: by buying up sterling on the foreign exchange markets. If market forces persisted in pushing the ‘natural’ value of the pound downwards, the pegged rate would become more and more difficult and then impossible to sustain.

Of course, Harold Wilson’s prohibition had no effect and was even counter-productive. Devaluation followed within months (1967) and the £ was then pegged at $2.40 to the pound. Repeated denials of an intention might sometimes become less convincing as they are repeated more often.

Speculation about Greece has not been uniform. Some say that Greece will withdraw from the Euro-zone or be removed from it; others say that they will default on their sovereign debt. Some say that both will happen. In fact, whichever happens, the other is likely to follow.

If Greece were to withdraw from the Euro-zone and restore the drachma, the value of the drachma would inevitably fall well below the value at which Greece entered the Euro-zone. This would make repayment of their debt, which was contracted in Euros, much more expensive to repay.

Therefore, withdrawal from the Euro-zone would almost certainly lead to a default on their debt, if not a complete repudiation of it.

The more likely scenario is that a default that was not by agreement would lead to a withdrawal or expulsion from the Euro-zone. Such a default would stop any new lending to the government (in the form of purchases of any new issue of Greek bonds) and would cause the value of existing Greek bonds to plummet. The absence of new lending would mean that the Greek Government would not be able to pay its bills or salaries of public employees or state benefits.

There would be disorders on the street that would dwarf any that have already been seen. The plummeting in the value of existing government bonds would lead to huge deficits in the balance sheets of Greek banks (not to mention many overseas banks) and a shortage of money through- out the economy. Unless the countries in the Euro-zone (and possibly the EU as a whole) were to inject fresh loans to keep Greece in the Euro-zone, Greece would have to withdraw and restore the drachma.

Greece would then be able to supply the money necessary for the economy to operate with some efficiency but with the ever-present threat of inflation. The fall in the value of the drachma would lead to a boom in those of its visible and invisible exports that were price elastic. This might lead to a boom in those sectors of the economy to the envy of other debt-ridden countries in the Euro-zone.

Would that be an end to the story? If so, even the most enthusiastic Europhile might accept the withdrawal of Greece as a price worth paying for the survival of the Euro-zone. However, that would not be the end of the story.

A Greek default – either preceding or following withdrawal from the Euro-zone – would raise the fear that other countries would default on their debts. This would lead to drastic falls in the market value of their government bonds.

This would increase yields (percentage returns on the market price of the bonds). Whilst that would not have an immediate effect on the governments concerned, any new issues of bonds would need to increase considerably the ‘coupon’ or percentage of the face value or nominal value printed on the bonds, so that the yield (percentage return on the market price) equalled those of  already issued bonds.

Furthermore, banks in these ‘other debtor countries’ that have bought quantities of their governments’ debts would find a hole in the assets of their balance sheets. This would lead to restrictions on lending and a brake on their economies.

Resulting falls in tax revenues would lead an inability of the governments of these countries to pay their bills or even the salaries of public sector staff. They would see the attraction of following in the path of Greece. A restoration of their own currencies would see it fall in value compared to that of the Euro.

This would make repayment of debt so much more expensive and make default more and more likely. However, the fall in the values of their currencies would see an export boom, at least in sectors, such as tourism, that are price elastic.

The effects would not end there. The remaining countries in the Euro-zone would notice the adverse effects on their economies of the export booms of the countries freshly released from the Euro-zone.

There would be (unmet) demands from their citizens for import restrictions, threatening even the free trade aspect of the European Union. Furthermore, those countries in which their banks held significant amounts of defaulting countries’ sovereign debt would discover holes in the assets on their balance sheets.

The exit of Greece from the Euro-zone could bring about its complete dismantling and even threaten the more fundamental aspects of the European project. It is small wonder that the Europhiles are so desperate to keep Greece in the fold. They have been (as a previous Lord Salisbury once said about Iain MacLeod) too clever by half.