Dra(ch)matic end to the Greek tragedy

Receding fears of a Greek sovereign default lifted markets on Friday even though not all the details on the Eurozone’s new €130 billion bailout package have been resolved.

Greece will probably come to some sort of agreement with official and private creditors before its €14.5 billion bond redemption on March 20. This would postpone a disorderly default and departure from the Eurozone, but some analysts have been arguing exit would be the best option, both for Greece and the currency zone.

Although he thinks there is a 50 percent chance the drachma will reappear over the next 18 months, Citi chief economist Willem Buiter argues this wouldn't be very “dra(ch)matic” for the rest of the Eurozone. For one thing, correlations between the cost of insuring Greek debt and other peripheral countries have recently broken down. This suggests that contagion may not spread.

Besides, Eurozone banks will have had plenty of time to cut their exposure. The second round of the ECB’s three-year loans and the recent relaxation of collateral rules should help as well.  As Greek PM Lucas Papademos lamented recently, “many in the Eurozone don’t want us anymore”. Maybe, that’s because Eurozone officials now believe they can contain the consequences of a Greek exit.

Analysts are arguing that returning to the drachma would be beneficial for Greece as well by allowing it to regain competitiveness through devaluation. An oft-given example is Argentina’s exit from its currency board in 2002 and the strong economic performance that followed.

Writing in this week’s Economist, Mario Blejer and Guillermo Ortiz, former central bank governors of Argentina and Mexico, argue that these views vastly understate the true cost for Argentina. They note the bank run that followed and the renegotiation of contracts, which led to massive bankruptcies. They advise that it would be much better for Greece to remain in the Eurozone.

That may not be possible even if Greece wants to stay. Bond investor PIMCO’s CEO Mohamed El-Erian sees strong similarities between the current mess and what was happening in Argentina in 2001, suggesting that the country is on the same path to default and chaos unless officials act fast.

But neither the former central bank governors nor El-Erian is clear on exactly what needs to be done for Greece to stay in the Eurozone: They talk about reforms and institutional changes. This sounds awfully similar to Paul Krugman’s confidence fairy, the myth that fiscal austerity will solve all of Europe’s problems by restoring confidence.

Blejer and Ortiz acknowledge that regaining competitiveness without devaluation is difficult. Even after falling over the last two years, Greece's real exchange rate, based on unit labor costs, is still nearly 15 percent higher than a decade ago. Besides, the Greek economy has already contracted 16 percent since the beginning of the crisis, compared to Argentina's 20 percent and 29 percent in the US during the Great Depression. Greeks simply cannot take much more.

Maybe, Eurozone officials are just buying time and paving the way for an “orderly” default and exit for Greece, and markets are just dancing while the music is still playing.