The best default Greece could have

A Greek default sooner or later seems inevitable. But the best option – postponing default to boost fiscal adjustment and chances of staying in the eurozone – sadly seems the least popular.

What would constitute an economically rational choice for Greece, given the economic and political situation? I see four options, each of which is fraught with uncertainty.

The first would be the status quo: more austerity and economic reforms as outlined by the International Monetary Fund and the EU. One risk is that this would keep Greece in an eternal depression and a debt trap, where economic output fell faster than growth. Another is that, while on paper it might just work economically, it would almost certainly fail politically.

Indeed, that may already be happening. Syriza, the hard-left anti-austerity party, heads the latest opinion polls. If this result were replicated at a future election, it would also obtain the coveted prize of 50 additional parliamentary seats, a sixth of the size of the entire parliament. So this would end up with the triumph of extremist parties.

Since this option would work neither economically nor politically, it cannot conceivably be a rational choice.

The second option would be to pursue the same plan until Greece achieves a primary balance – the fiscal balance before the payment of interest – and then to default, or at least to renegotiate the program with the IMF and the EU. This is more realistic than the first option. A variant of this option was under discussion in the negotiations last week. But there is a risk the austerity needed to reach this point is either so severe, or would take so long, that the political risk would start to have an impact as well.

The third option is the one outlined by Alexis Tsipras, the Syriza leader. He wants Greece to cancel the program immediately, reverse some of the reforms and consider the possibility of a default on the remaining foreign debt. He claims this would not lead to an exit from the eurozone. He is saying that the EU is bluffing. I am not sure he is right about the latter. But then again, I am not sure he is wrong either.

What would happen if Greece cancelled the program unilaterally? For a start, the EU would stop the loans to Greece. Greece would then default on all of its foreign debt. But given the primary deficit, Greece would have to impose an even bigger austerity program. Assuming it still wanted to stay in the eurozone, could the others force it to leave?

The European treaties have no provision for euro members to leave the single currency and certainly no provision to kick somebody out. The treaty also says the currency of the EU is the euro. Technically, the European Central Bank could decide not to accept Greek bonds as collateral. It could refuse to grant a request for emergency liquidity assistance. Greece would then have no choice but to leave "voluntarily”. But this would be an incredibly hostile act.

Wolfgang Schuble, the German finance minister, is confident the eurozone would withstand a Greek exit. This reminds me of his judgment last year when he said the eurozone could easily cope with a voluntary participation by bondholders. This may turn out to be another in a long string of misjudgments. I expect investors to bet more aggressively on a break-up if Greece is forced out.

There are also uncertain risks of financial contagion. As Fitch Ratings said at Friday’s coalition talks, a Greek exit would have a negative impact on the eurozone’s ratings. Tsipras has a point when he says the EU has no interest in pushing Greece out of the euro. The trouble is the eurozone may still do it because its leaders misjudge the situation.

The fourth option would be an immediate voluntary departure. Greece has only a tiny export sector and, as Willem Buiter of Citibank has said, the initial competitiveness gains would be quickly eroded through domestic policies.

Of the four, the worst option is actually number one. By following the EU-IMF program, Greece will end up with 10 years of depression, an inevitable euro exit and a possible breakdown of democracy. The best option, in my view, would be a strategy to achieve a primary balance by 2013 and then to default on all outstanding foreign debt, public and private. It would not be popular outside Greece but it would be hard to push Greece out of the eurozone.

I consider Tsipras’s approach too risky. But I can see why Greek citizens would vote for him. His position is certainly more rational than that of the austerity centre-ground establishment, which can offer no perspective of an economic turnround. This is Germany in the early 1930s all over again.

This leaves us with a choice between default later and default now. I would prefer default later because it would make for a smoother fiscal adjustment, bring a few sensible reforms and increase the probability that Greece could stay in the eurozone.

Sadly, the political momentum is swinging the other way.

Copyright The Financial Times Limited 2012

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