Why doesn't Greece simply default?

A second aid package to the Greek government hinges on severe austerity measures. Why doesn’t Greece simply default and leave the euro as so many Greek protestors demand on the streets of Athens?

In my book The Tragedy of the Euro, I explain that the euro is a political project. Proponents of the socialist vision of Europe, under the leadership of French political elites, pushed for the single currency as a vehicle to political centralisation and a European super state.

The monetary setup of the Euro leads to redistribution in favour of more profligate governments residing mainly in the south of Europe. When I make this argument, I sometimes hear the counterargument that the main profiteer from the euro would not be the proponents of the socialist vision of Europe and southern states but rather Germany.

The argument is quite common among press commentators and economists alike and goes as follows: the single currency has made competitive devaluations impossible. Southern states that are not competitive cannot devalue their currency anymore to gain an advantage. Thus, Germany can export more and is therefore the main beneficiary of the euro ripping off the periphery. This opinion is not only propagated in southern Europe. Even in Germany, Chancellor Angela Merkel has used the argument of higher exports to justify the bailout fund (European Stability Mechanism).

First, a caveat must be applied: there are only individuals that benefit or lose from an institution such as the euro. Whole countries do not act and cannot benefit or lose in a strict sense. In Germany, some people have won and others have lost due to the euro.

Putting these considerations aside, it should be emphasised that exports alone do not make someone happy. Let us apply the reasoning to an individual. When someone works, he exports services to the rest of the world. When he sells his stuff to others, he exports goods. The individual does not do that because he likes exporting per se, but rather because he wants to import sooner or later. When he buys a car or groceries or gets a haircut, the individual imports goods and services. If one had to choose between only exporting (working and giving away goods) and importing (consuming), most people would choose the latter option.

Indeed, southern euro countries have opted for the latter. They import more from Germany than they export to it. The result is German export surpluses interpreted by German politicians as a great success. Other eurozone governments have criticised Germany for having export surpluses, i.e. giving more goods away than it receives. On the EU level, some have even suggested punishing countries for having export surpluses that are too high. Apparently, it is a crime to be too competitive and give away goods without receiving anything in return. Maybe as a punishment even more goods should be shipped to countries with import surpluses.

Why can southern states have enduring import surpluses? The answer to this question brings in the European fiat currency, the euro. Several independent governments can use one banking system to monetise their debts.

Let us examine the case of Greece. The Greek economy with wage rates that are too high is no competition to innovative German industry enjoying moderate wage increases. 

The result of these artificially high Greek wages would be poverty and unemployment. These effects, however, are partly counteracted by the profligate spending of the Greek government. To finance the spending, the Greek government simply prints bonds. Transferring new funds to the Greek government, the banking system buys these bonds and uses them as collateral for new loans from the European Central Bank (ECB), which thereby monetises the government deficit. The Greek government uses the new money to pay for early retirement schemes, an army of public servants and generous social benefits. The Greek economy’s lack of competitiveness is thereby sustained and increased.

For instance, the Greek government could issue a bond, receive new money and pay a minister. The minister buys a BMW with the new money. As a result prices in the eurozone rise and Greece enjoys a trade deficit with Germany. Greeks live beyond their means financed by the issuing of government bonds and the production of new money. Cars flow into Greece in exchange for new euros and debt promises. Europeans from fiscally more responsible states pay the bill in form of higher price inflation and since 2010 in form of direct guarantees for subsidised loans to the over-indebted Greek government. As the Greek government benefits from the euro, it does not want to default and leave the eurozone despite the riots in the streets.

A second edition of The Tragedy of the Euro (updated and improved) is available here and here.

This is a very important point not made frequently enough - indeed, I am not sure of anybody else making this point consistently. There are many possible end games to the problem we have. One is for Greece to exit the euro and introduce its own currency (whether a sound currency or not), but let's assume for the moment that the Greeks stay in the euro. It is difficult to imagine that this can happen under current monetary arrangements without complete fiscal centralisation because of the way in which the ECB conducts monetary operations. However, I think it is possible, in principle, to have a single currency without centralisation but it would then be necessary for the ECB not to accept bonds of all countries in repo arrangements (indeed it could conduct its monetary policy in an entirely different way). My own parallel currency suggestion would require changes in the way in which the ECB conducts its monetary operations, but it seems to me that these are easier to achieve than a complete unwinding of the euro and is certainly more desirable than fiscal centralisation.
You're right to emphasise the political agenda of the Euro, the economic justifications behind many periphery countries joining the Euro of convergence were very suspect. The political ties are both the reason they got into the Euro and why they will probably remain in the Euro. The negative shock that could spread through Europe if they defaulted, coupled with the fact that under current rules you can't just leave the Euro, you must also leave the EU; means they risk becoming a political outcast with a currency no one would dare touch. Great for exports and debt relief for sure if they were able to form a new currency but inflation could then become a huge problem not to mention the sheer logistics and time needed to re-introduce the currency. Barry Eichengreen wrote an interesting short piece on this issue 'stress test for the Euro' in 2009 highlighting why exit is very unlikely.

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