Papendreou Agonistes: Greece Throws Down The Gauntlet

For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational.  Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece.  The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.

If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances.  A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.

Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time.  However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France.  Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.

The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.

Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union."  Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"

The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s.  As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances.  That's where the EU is today.

We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."

Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."

Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank.  He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!

As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage." 
This recapitalisation itself will be a Herculean undertaking.