Greece: deflate or default

The original worry was whether Greece would default. Then it became a question whether it should it default. Now it is a question of how it will default. To hazard a guess, I should think that after the wizards of Brussels determine how much of a default is necessary to keep German (et al.) bail-out money forthcoming, the only remaining question will be when the default will occur. It is clear that the vast majority seem convinced that default is the only option, or that it is the best one, or, at the very least, that it is the most expedient one at this time.

Default is not a word to throw around casually. When an individual defaults on his mortgage, it involves great pain – he loses his house, his car, and whatever other assets he posted as collateral. Default does not mean that debts are forgiven and he starts afresh (although the vulgar form of default seems to imply this). Default causes our individual pain – it is something that he tries to avoid at all costs.

Before the Greek default occurs – which is increasingly becoming a foregone conclusion – we must look at two facets. First, what will this default mean? Second, is there a better way?

A nation can default two ways. Implicitly, by inflating the real value of its debt away by increasing the money supply, or explicitly, by not paying back the full value of its debts. If the eurozone is to continue to include Greece as a member, it is clear that an implicit inflationary default is impossible. (Some commentators seem to belabour this point, as if Greece exiting the euro and inflating away its problems would prove a panacea.) With this avenue gone the attention focuses on the explicit default, soon to be delivered.

Haircuts imposed on creditors form what seems to be the preferred planned default. In reality, a haircut only allows for one-half of a default to occur.

The half that we will see is the pain imposed on creditors. Lenders kind enough to loan their funds to the Greek government likely never expected that they would not be repaid. At least, they likely never expected the extent to which they would not be repaid (which could be as little as 20 to 50 cents on the euro). It is easy to take solace with caveat emptor, but that is only half the story.

If I default on my house, it is not only my bank that suffers a loss; I must as well. I must lose all available assets in an attempt to make my bank as whole as possible. There are not so many plans to sell Greek government assets to pay for its debts (of course, the related question is whether anybody would want such assets. I am sure that few creditors would rather take a union-saddled Greek government agency, complete with strike-induced headaches, rather than cut their losses at 100 percent).

If Greece wants to default, it must abide by the rules of the game. The current “default” plan for Greece is nothing of the sort; it is a gift. Few Greeks seem willing to sacrifice sovereign control to foreigners by relinquishing assets, and perhaps rightly so. But if assets will not be sold to try to cover its debts, Greece must look for a different avenue to default.

Cutting expenditures is one path. While Greeks strike at the very thought, if the choice was clear to them – lose sovereign assets to take a cut on your pension – their attitude might quickly change. Creditor nations avoid this trade-off by being ambiguous as to what a Greek default would actually mean to Greeks. This very ambiguity makes the game continue longer than it must. As excessively high expenditures are what got the country into the mess to begin with, it seems to be a logical place to start to try to exit recession. Austerity might be a dirty word, but it is a necessary one.

There is one other option left to the small Hellenic republic. It is not without precedent, but it too is a dirty word in some circles. Greece may not be able to pursue an external devaluation through inflation, but she can pursue an internal devaluation through price decreases. Deflation might cause some to run to the exits, but it is increasingly proving its worth. Ireland has recently started exiting its recession through deflation, and occurrence making it ever less likely that the country will default. Deflation is not necessarily easy – public and private workers will have to take salary cuts, austerity programs will have to be intensified (and fulfilled!) – but it allows the country to avoid the costs of losing national sovereignty and creditors taking losses on their loans. Some may think deflation is a dirty word, but no more than the alternatives. And it has already been successfully tested in other ailing European economies.