Greek referendum: Why is this surprising?

Imagine for a moment that you have a gang of feral youth on your street who have the habit of stealing everything from car keys to roses from the front lawns; and then hawking them off back to you and your neighbours from the street corner; living off the proceeds quite grandly with new clothes, sneakers and long beach holidays. One fine day after an old woman is mugged by this gang all of you get together and decide to teach these youth a lesson but cannot decide whether a long spell in jail or a short spell in backbreaking community service is the best way forward.

So, you decide to ask the gang of youth to decide amongst themselves, democratically of course, which punishment they prefer; and if they preferred none they would need to leave your street. The gang of youth put to the vote two different questions though — namely do they reject your authority or accept your authority (not the two choices between jail and community service you had outlined). Predictably, more than 60% of the youth vote to reject your authority; and instead want you to be more accommodating given their youth and upbringing. Next morning, you express surprise at their decision.

For anyone scratching their heads about just what happened over the weekend, the above story is a simplification – but not by much – of what just happened in Greece over the weekend (see “Bubble and Squeak” and “Politics IS Economics” on these pages). To be sure, a lot of blame is to be passed around, more or less equitably between the EU and Greek politicians. Alex Tsirpas and Yanis Varoufakis twisted the question to be about austerity (which the Greeks didn’t want) rather than about the euro (which they do want); and now they claim a national mandate for demanding debt relief (which was never in question even before the referendum).  For their part, European politicians have played fast and loose with the facts, failed to confront reality and pretty much done everything that I predicted they would do on these pages many moons ago, when I wrote “The men without qualities” – Oct 29, 2011. Note to self – even though two of those leaders changed with Sarkozy and Berlusconi out of the picture – nothing else changed; hence the golden constant for European politics remains that all politicians are beige.

From the point of view of someone more sympathetic to the Austrian school of economics, the current crisis in the euro merely proves a few things that were well known for a while:

• You cannot borrow your way out of a debt crisis
• “Bagehot principles” must be adopted when rescuing banks
• Productive capacity must expand to justify money printing
• It’s always better to take a loss today than postpone your losses to tomorrow

What are the “Bagehot principles”? Named after Walter Bagehot, there are 3 rules for central banks to rescue commercial banks that are in the middle of a bank run or otherwise facing massive losses – rule 1, make adequate liquidity available; rule 2, only accept good collateral and rule 3, charge a penal rate of interest

Instead, the EU adopted a number of rules that violated these precepts, sometimes egregiously:

1. The Greek government – a bad credit – was allowed to borrow more money; thus a credit crisis was mis-diagnosed as a liquidity crisis.
2. Despite a near default and serial downgrades by rating agencies, the ECB acting on political instructions expanded the definition of allowable collateral repeatedly to include Greece sovereign debt. Despite this, on every rollover and refinancing, private banks sold off their Greek government bond positions, leaving almost the entire amount in the hands of public institutions (only about €50bn of the €320bn of Greek sovereign debt is now thought to be in private hands; its quite likely that the net figure is a lot lower).
3. Strangely despite the relaxation of credit standards, the EU did not provide adequate liquidity so the Greek government never had sufficient liquidity to plan anything for over a few weeks at a time.
4. Interest rates were set far too low to effect any change of behaviour from the Greek government; indeed instead of allowing the market to set rates the EU explicitly acted against free markets by banning the shorting of European government bonds and synthetic shorting by purchasing protection through CDS contracts; this had the effect of switching off a spaceship’s radar when trying to fly through an asteroid belt. Without any reasonable market input from the marginal risk taker (i.e. anyone willing to purchase risk at a given time), interest rates were set far too low for the Greek government; in turn perpetuating bad behaviour and postponing the day of reckoning when all debts fell due.

So what are the options now? Broadly, there are two camps:

1. Greek exit from the euro, but stay inside EU. Just like other countries including the UK and Denmark which are inside the EU but outside the common European currency, Greece can revive the drachma. This would mean a few things:
   1. Greek sovereign debt is written down (haircut) by creditor countries
   2. Domestic obligations such as pensions are converted to drachma, hence heavily devalued in effect

• Greek government will now have to find investors for bonds denominated in the new currency and pay market rates of interest for the same

1. Not to put too fine a point to it, the needs of (ii) and (iii) would clearly necessitate significant and real austerity by the Greek government
2. German subsidies continue. This is the scenario that the Greeks are playing for:
   1. Greece remains inside the euro for strategic (NATO), humanitarian (sympathy from other members) and political considerations
   2. There is a massive haircut on sovereign obligations, and alongside, a continuance of the current welfare regime

• Without an ability to impose structural reforms and demand austerity, in effect the Greek economy would be socialized across the broader European economy; free to run its deficits and behave as Syriza would like them to

I think the final scenario would be some sort of amended version of Scenario 2, but only if the first scenario is taken seriously and understood by the Greek population. On current indications, this is extremely unlikely over the short-term. Meanwhile, German politicians are likely to emerge from the woodwork demanding that Scenario 2 never plays out; therefore there will be a lot of noise in the next few weeks.

If any reader had been planning a quiet summer holiday, forget it.

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