Greece's long road to default

It was a deal nobody believed in – including those who negotiated it. We are now going to go through the motions but Greece will default, one way or the other. The question is when and how.

Paul Krugman observed in his New York Times blog that Greece was trapped between an austerity program that forever aggravates the debt problem, and a default that will not be feasible until the country reaches a primary surplus – a budget surplus after payment of interest on debt. This is not expected to happen until 2013. As a result, he wrote, the Greek political establishment would have no choice but to wait and see.

This is right, but it could do more: it could prepare for a total external default next year. That means it would need to persist with austerity this year simply to bring the primary deficit close to zero. And it would also have to enact some structural reforms to reap the benefits a default could bring.

On the heroic assumption that the agreed private sector participation stabilised Greek debt at 120.5 per cent of gross domestic product, as targeted by Tuesday's agreement, a default would invariably mean 'official sector privatisation'. It would have to include the loans by the European Financial Stability Facility and the bonds held by the European Central Bank and various national central banks. Greece might also default on some or most of its remaining private sector bonds. By default I mean a renunciation of most of its foreign, but not necessarily domestic, debt. The goal would be reduce the total debt-to-GDP ratio to 60 per cent.

If a default were to result in an exit Greece would introduce its own currency, at a nominal conversion rate of one-to-one against the euro. The new drachma would devalue substantially. Greece's manufacturing export sector, accounting for about 7 per cent of economic output, would gain substantially, but not enough to lift the country out of its crisis. Tourism accounted for 18 per cent of GDP in 2008, but Greek holiday destinations have become very expensive and, to remain competitive, prices would need to come down – ideally by some 50 per cent. This could not be done through an internal devaluation, where nominal wages and prices were reduced. The sum of tourism and exports, plus the prospect of strong export growth as the terms of trade improve, should be sufficient for a euro exit strategy to work – but only if it is well prepared and executed.

The irony is that Greece would still need to implement reforms similar to those that international lenders are currently demanding. The government would need to be able to collect taxes. It would have to stamp out corruption. It would need to ensure a substantial degree of labour market flexibility. Trade unions would need to be blocked from negotiating wage increases that offset the benefits of a nominal devaluation. Greece needs a big double-digit real devaluation, which would require a wage adjustment. The government might need to supplement such a strategy with an outright incomes policy.

A milder version of default would include a program that allowed Greece to stay in the eurozone. A minimum precondition for negotiating such a program would be that trust is rebuilt. Greece would need to stick to the spirit and letter of the agreement, and the European Union would have to accept that it must write off its loans to Athens.

In the short term, the latest program will worsen the recession. At some point, the Greek government could argue that it is unrealistic and should be replaced by one that includes debt forgiveness.

Greece also needs growth. A default inside the eurozone would not improve its competitiveness. For the strategy to have a chance, a growth engine would have to be constructed externally. This could come only in the form of a large EU investment program. If every step of the process worked perfectly, this would be the least malign scenario. It requires an improbable degree of goodwill and readiness by all parties to make sacrifices, however.

Of the two options, the first is more probable, the second more desirable. Greece does not need to decide right now which one to pursue. The priority of the next government should be to prepare the ground for both options. Another year of misery lies ahead. But if all goes well, Greece will have finally gained some room for manoeuvre.

Copyright The Financial Times Limited 2012.