Hugo Dixon

Greece needs to go to the brink. Only then will the people back a government that can pursue the tough programme needed to turn the country around. To get to that point, bailout cash for both the government and the banks probably has to be turned off.

It might be thought that the country is already on the edge of the abyss. This month’s election savaged the two traditional ruling parties which were backing the bailout plan that is keeping the country afloat. Extremists of both right and left gained strength – voters liked their opposition to the plan. But nobody could form a government. Hence, there will be a second election on June 17.

Will this second election express the Greeks’ desire clearly: stick with the programme and stay in the euro; or tear up the plan and bring back the drachma? That is how Greece’s financial backers in the rest of the euro zone, such as Germany, are trying to frame the debate. But the electorate doesn’t yet see the choice as that stark. Roughly three quarters want to stay with the euro but two thirds don’t want the reform-plus-austerity programme.

The next election is unlikely to resolve this inconsistency – or at least that is the conclusion I came to from a trip to Athens last week. The battle for first place is between Alexis Tsipras, the young leader of the radical left SYRIZA party, and the centre-right New Democracy party led by Antonis Samaras.

A victory for Samaras might seem to offer the hope that Greece will stick with the programme and the euro. He has, after all, campaigned for both. However, even if he comes first – which he did in this month’s election – he will not have a parliamentary majority. He will either have to stitch together a majority coalition or govern a minority government. Neither is the recipe for a strong government.

A Samaras government could theoretically deliver a positive shock by moving full-steam ahead on reforms and gaining so much credibility with Greece’s euro zone partners that they give Athens real help in turning around the country. But it is far more likely that he will be timid and the rest of the euro zone will throw Greece only a few crumbs. The economy, which has gone from bad to worse in the last couple of months of electioneering paralysis, would continue its nosedive, Samaras’ popularity would evaporate and after a few months his government would collapse.

A victory by Tsipras in next month’s election might seem even worse. After all, he will probably set Athens on a collision course with the rest of the euro zone. Last week Tsipras likened the relationship between Greece and the euro zone to that between Russia and America in the Cold War, when both had nuclear weapons that could destroy the other but refrained from firing them. Tsipras thinks the rest of the euro zone is scared that Greece’s return to the drachma would cause the entire single currency to unravel and that the bail out of Athens will continue, even without substantial economic reform.

The impact on the euro zone of Greece’s expulsion would undoubtedly be severe. But the other countries are finally preparing contingency plans to mitigate the damage. Germany, for one, will not be blackmailed by threats of mutually assured destruction.

It is conceivable that Tsipras will blink first, if he wins the election and finds he can’t shift the Germans. But this is unlikely. The typical weasel words of a politician won’t be enough to get him out of a tight spot; he would have to perform a complete somersault. It is doubtful the Marxists in his party would let him get away with this and, if they did, he would certainly lose all credibility in the country.

That said, a victory for Tsipras may paradoxically be Greece’s best chance of staying in the euro because it would bring things to a head rapidly. The country is being kept alive by a dual life-support system: the euro zone and IMF are channelling cash to the government, while the European Central Bank is authorising cash transfers to the banks. If the first tap is turned off, the government will not be able to pay salaries and pensions from July. If the second tap is turned off, the banks could run out of cash within days.

Cutting off Greece’s life support could be the trigger for reintroducing the drachma as the people found the cash machines ran dry. But it could also finally force the people to decide whether they were prepared to back reform – provided the euro zone simultaneously rolled out a proper plan to help the country. A key element of that would have to be to take over the Greek banks and guarantee their deposits, putting the country into a form of financial protectorate.

In such a scenario, a Tsipras government would probably collapse. After all, even if he comes first in the next election, he will not have a majority and so would be relying on coalition partners or governing in a minority. Greece would then need a third election, after which it might be able to put together a national unity government – perhaps even led by Lucas Papademos, the technocrat who ran the country for the last six months.

It is a slim chance full of risks, but probably Greece’s best chance of avoiding the drachma.

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises – it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.

But the European people are not remotely ready for such steps. Anti-euro sentiment is on the rise, to judge by strong poll showings by the likes of France’s Marine Le Pen and Italy’s Beppe Grillo. Germany’s insistence last December on a fiscal discipline treaty has stoked that sentiment.

An attempt by the region’s elite to force the pace of integration with even more ambitious plans could easily backfire with voters, particularly in northern Europe. They would fear being required to fund permanent bail outs for feckless southerners. Premature integration might not even help with the current crisis if it backfired with investors. They might start to question the creditworthiness of a Germany if it had to shoulder the entire region’s debts.

In contrast, the principle of “subsidiarity” – the Maastricht treaty’s specification that decisions should be taken at the lowest possible level of government that is competent to handle them – is good politics and good economics. Of course, even advocates of political union such as Wolfgang Schaeuble, Germany’s finance minister, subscribe to this principle. The issue is to define the minimum conditions needed for the sustainability of the single currency. There are probably three.

The first is that insolvent entities – whether they are governments or banks – should have their debts restructured. One of the main reasons states and lenders were allowed to leverage themselves so much in the boom was because there was a widespread view that they couldn’t go bust. The complacency sowed the seeds of the crisis.

Meanwhile, a key mistake in managing the crisis was the failure to restructure Greece’s debts as soon as they became unbearable. If that had been done, private-sector creditors would have taken the hit. Instead, they were largely bailed out – with the result that 74 percent of Athens’ outstanding 274 billion euros in debt is now held by governments and the International Monetary Fund, according to UBS. This means taxpayers will be on the hook when the big fat Greek default occurs.

Of course, if Greek debt had been restructured earlier, banks in the rest of the euro zone would have had big holes in their balance sheets. Some would have needed bailouts from their governments. But that would have been better than the current debilitating long drawn out sovereign-cum-banking crises.

What’s more, in the future, insolvent banks shouldn’t be bailed out either. Their creditors should be required to take losses before taxpayers have to stump up cash. The failure to do so explains why the government of Ireland, previously financially solid, become infected by its lenders’ folly.
The second minimum condition for monetary union to flourish follows the first: there should be liquidity backstops for banks and governments that are solvent.

With banks, the natural liquidity backstop is the European Central Bank. The quid pro quo is that lenders have to be properly capitalised. Time and again throughout the crisis, euro zone governments have ducked this issue. Only this month, France and Germany conspired to dilute the Basel 3 global capital rules as they apply to Europe, while Spain imposed another half-hearted restructuring on its banks. If the euro zone’s leaders want a successful single currency, this nonsense has to stop.

For governments, the natural liquidity backstop is the European Stability Mechanism, the zone’s soon-to-be-created bailout fund. To do its job properly, it will need extra funds – as it isn’t be big enough to help both Spain and Italy. One option could be to allow it to borrow from the ECB.

Again, the quid pro quo would be solvency. Insolvent government would only get access if they restructured their debts. And illiquid but insolvent ones would need credible long-term plans to cut their debts. Italy, with debt over 120 percent of GDP but huge private wealth and state assets, might one day find itself in the latter category. In return for liquidity, it might have to agree a multi-year programme to privatise real estate and to tax wealth.

The final minimum condition for a successful monetary union is much more flexibility, particularly in labour markets. This is the key to restoring competitiveness in southern Europe and enabling the zone to respond to future shocks.

If the euro zone can do these three things – restructure insolvent institutions’ debts, provide liquidity to solvent ones and improve flexibility everywhere – nations will be able to keep both the euro and much of their sovereignty. That’s a preferable vision to either a euro super-state or the chaos of disintegration.

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Depositors in other peripheral countries would pull savings from their banks. Bond markets in these other countries would also seize up. Why would anybody want to lend money to Rome or Madrid in euros if they thought they were going to be paid back in devalued liras or pesetas?

The solution proposed by most Wolfson Prize finalists is secrecy. Plans for a country’s exit from the euro should be kept under wraps and then sprung on the unsuspecting world on a Friday evening. But this is impractical. How could 17 governments keep secret something that will involve lots of wrangling? Would a democratic country really be able to foist such a momentous decision on its people without a parliamentary debate? Even if secrecy was possible, it wouldn’t stop contagion to other countries.

Catherine Dobbs, a private investor who used to develop algorithms for an investment firm in the City of London, has come up with an ingenious solution. At the point of break-up, every euro – wherever it is located – is replaced by a basket of two (or more) new currencies. This is a radical shift in thinking. Until now, most people had envisaged all economic activity in the exiting country being redenominated in its new local currency while all the other countries kept the euro.

Dobbs illustrates her idea using the unscrambling the egg metaphor. The euro zone is broken up into two sub-zones: the yolk and the white. For some bizarre reason, she equates the yolk with the periphery (Greece, Spain etc) and the white with the core (Germany, the Netherlands etc). But I’m going to flip it round as it’s more intuitive to think of the yolk as the core. The idea is that every euro is swapped for a fixed ratio of yolk currency and white currency, roughly in proportion to the relative size of the two sub-zone’s economies. Say for every euro, people got 70 percent of a yolk and 30 percent of a white.

Once this has happened, the yolk and white are free to float – with the yolk presumably appreciating and the white currency depreciating. New contracts are denominated in yolk or white. But existing euro contracts have to be honoured by delivering the fixed proportion of yolks and whites in the basket.

The one exception to this – which Dobbs hints at but doesn’t spell out – would be employment contracts: they would need to be redenominated into their new local currency. This would effectively allow wages in the periphery to fall, which is vital if competitiveness is to be restored.

The beauty of the scheme is that there’s no incentive for citizens in the periphery to grab their savings in the run-up to such a switchover and pop them into a core bank. Their euros will be worth the same wherever they are located. As a result, the detailed planning for the break-up can be done in public rather than in secret.

Neat as Dobbs’ idea may be, the politics of it are problematic. While savers in peripheral countries would like receiving a mixture of yolk and white for their euros, those in core countries could hate it. They would feel that a chunk of their savings was being forcibly swapped into the weak white currency even though, in theory, the value of the basket should still be one euro. Workers in the periphery who would be paid only in the depreciating white currency wouldn’t be happy either. While their wages would effectively be slashed, their debts, rents and other costs wouldn’t be. Many would face hardship and bankruptcy.

Perhaps that is just too bad. Somehow wages have got to come down in the periphery and devaluation would be a faster way of getting there than the current grinding austerity, which isn’t pleasant either. The snag is that such vested interests mean it’s most unlikely that heads of government could discuss the yolk/white scheme one day and back it. Rather, there would be lots of debate over what the right plan was. And before any decision had been reached, there would have been a massive capital flight. Sadly, the euro egg looks pretty well scrambled.

The euro zone is like Hotel California, UBS wrote in a report published in September. “You can check out any time you like but you can never leave,” it said, quoting the Eagles song. A British businessman, Simon Wolfson, has now offered a 250,000 pound prize to the person who can come up with the most convincing explanation of how an orderly exit from the single currency is possible.

The problem is the word “orderly.” There are lots of scenarios where a country such as Greece could quit the euro in a disorderly fashion, destroying its own economy and that of its neighbous as well as possibly plunging the world into a recession. But how is it possible to do this without triggering financial Armageddon?

The first difficulty stems from the fact that an exit couldn’t happen overnight. There is no legal procedure for a country to quit. Joining was supposed to be an irrevocable commitment.

Treaties can, of course, be renegotiated or broken. But this couldn’t happen rapidly -– or, more to the point, secretly. There are 17 members of the euro zone; and another 10 European Union members such as the United Kingdom, which don’t use the single currency. If Greece wanted to reintroduce the drachma, it would have to secure the unanimous agreement of these other nations. It is also inconceivable that it could take such a momentous decision without discussing it in parliament. Predict weeks, if not months, of heated wrangling.

Such debate would frighten the horses. Many depositors have already removed their savings from Greek banks. An open discussion about Athens leaving the euro would trigger a stampede. The whole point of bringing back the drachma would be to devalue it in the hope of making Greek industry competitive. Analysts think the initial fall might be 50 percent. If so, anybody patriotic enough to keep their money in a Greek bank would lose half their savings.

Transitional mayhem
Athens could then do three things: allow its banks to collapse; appeal to its euro partners for help; or impose controls on how much money people could take out of its banks.

Allowing banks to collapse in a disorderly fashion would be mad. It would be a sure-fire way to cause economic chaos and social disorder. The recent street protests would seem like a tea party.

Getting help from the euro zone would be ideal. But why would its euro partners want to bail out Greece’s banks, if the country was on the point of quitting the euro? The European Central Bank has already stopped making new loans directly to some Greek banks because they have run out of high-quality collateral. Instead, it has authorised the Greek central bank to provide liquidity, with Athens theoretically on the hook for any losses. But if Greece was about to quit the euro, the ECB would be worried that it would never get paid back. It would hardly want to authorize yet more lending as this could just increase the size of its future losses.

So Athens’ only choice would be to control how much people could take out of their accounts. It would be like wartime –- with savings rationed instead of butter and bread. This wouldn’t be as bad as allowing banks to collapse. But it would still plunge the country deeper into misery.

Brave new economy
The hope, of course, would be that Greece would eventually rebound on the back of a super-competitive drachma. Northern Europeans would flock to its beaches to enjoy half-price retsina and feta. Maybe. But there would be two other questions: how would the government finance itself; and how would inflation be contained?

Athens has too much debt. The latest forecast from the Troika (made up of the International Monetary Fund, the ECB and the European Commission) is that debt will reach 183 percent of GDP by the end of next year. That debt load will loom even bigger if Greece quit the euro. In drachma terms, assuming again a 50 percent devaluation, debt would rocket to 366 percent of GDP. The government has to default even if it stays in the euro; but the extent of the haircut would be bigger if it quits.

Greece also has a primary budget deficit: it is earning less than it spends even before interest payments. A unilateral default would make it a pariah state. Nobody would lend it money to finance its ongoing deficits. That would provoke an even more severe recession in the short run. The government would also be tempted to print lots of new drachmas to fill the hole in its coffers, fueling inflation and debasing the currency.

To avoid such a nightmare scenario, Greece would need to secure an orderly default if it quit the euro. The best hope of achieving that would be to cut a new agreement with the IMF. Most but not all of its debts would be cancelled. But it would have to agree to tight fiscal and monetary policies to make sure it didn’t run up new debts or descend into hyperinflation. In return, it would get some hard currency to manage the transition. But even with such a balm, the journey would be painful.

Vicious contagion
Unfortunately, the problems with a Greek exit from the euro would not stop with Greece. Contagion would be far more virulent than anything witnessed so far.

Seeing what was happening to Greek depositors, savers in Ireland, Portugal, Spain and Italy — and possibly even France and other countries — would run a mile. They would take their euros and deposit them in German, Dutch or Finnish banks. To stop a large chunk of Europe’s banking system collapsing, the ECB would have to authorise unlimited supplies of liquidity for an indefinite period of time.

The key decision would be whether to let any other countries go the way of Greece. Portugal would be seen as next in line because of its need to improve competitiveness. But Lisbon would probably not want to quit. Given that there’s no time to waste in the midst of a bank run, the least bad option would be to rally around all the remaining euro countries and insist they were permanent members of the club.

It might, though, be sensible to take the opportunity of a Greek exit from the euro to arrange simultaneously an orderly default of Portugal and perhaps Ireland while keeping them in the single currency. If their debt levels were cut to more sustainable levels, they would be in a better shape to withstand the whirlwind unleashed by Athens’ departure.

Wherever the line was drawn, it would have to be defended to the hilt. This wouldn’t just be about protecting depositors. Bond investors would believe more departures from the single currency were on their way. Portugal and Ireland don’t matter for the time being because they are supported by euro zone and IMF bailout programmes which don’t require them to tap the market for new money. But Italy and Spain, which are already suffering jitters, would be shut out of the market.

The convulsions from a bankruptcy of Italy, whose debt is nearly 2 trillion euros, would be so seismic that it shouldn’t be attempted unless there really is no alternative. But rescues by other governments wouldn’t be possible either. The region’s bailout fund, the European Financial Stability Facility, isn’t remotely big enough.

Financial jiggery-pokery — such as turning the EFSF into an insurance company to leverage its firepower — might just work in the current circumstances. But it wouldn’t have credibility if Greece was quitting the euro and there were bank runs across the continent. The best way to hold the line would be for the ECB to provide unlimited supplies of liquidity to struggling nations by massively expanding its purchases of Italian, Spanish and other sovereign bonds in the secondary market.

The good thing about the ECB is that there is theoretically no ceiling on how many euros it can print. The problem is that massive liquidity injections to both banks and governments could remove the incentive for lenders and countries to manage their affairs wisely. Once the storm had passed, it would be best to separate the illiquid institutions or governments from the insolvent ones and find a way of restructuring the debts of the latter in an orderly fashion.

But faced with the choice between an imploding euro zone or underwriting delinquency, the ECB would be best advised at least initially to plump for the latter even if that would involve eating its words. Still, there’s no disguising that it would be an unpleasant outcome.

An orderly exit from the euro is a virtual oxymoron. There are ways to minimize the damage –- principally by rationing access to savings during the transition, orchestrating an orderly default of the country that quits and unleashing the ECB as a lender of last resort to those that remain. Even with such a program, the economic damage would be huge. Without it, staying in Hotel California would seem like a holiday. The euro zone would become a towering inferno with everybody scrambling for the exits.

PHOTO: A banner featuring a Euro coin is seen on the European Commission headquarters building ahead of a European Union heads of state summit in Brussels October 26, 2011. REUTERS/Yves Herman