The Future Of Greece, The Euro And The Impact On Global Markets

by: James A. Kostohryz


I highlight some of my past predictions regarding the Greek crisis that have proven highly prescient.

Surprisingly, the fundamental teachings of Keynes, Friedman and Hayek all lead to the same basic diagnoses and proposed policy solutions with regard to the Greek crisis.

A solution is not near, but the resignation of Greek Finance Minister Varoufakis offers a ray of hope.

Financial markets have not fully digested all possible outcomes of the Greek crisis. The dawning of this uncertainty could catalyze a correction in global risk assets.

Greece is not directly very important to the global economy and financial markets. Therefore, ultimately, any indirect effects are likely to be limited and temporary.

In February 2010, I predicted that if EU forced IMF "shock therapy" style austerity on Greece in the midst of a recession, a major disaster in the Greek economy would result. In a separate article, I explained how given the similarity of the two situations, the Greek crisis was likely to follow a path similar to that of Argentina if the same IMF "shock-therapy" style medicine were applied. In another article, I clearly explained that the resolution to the Greek crisis would likely only occur after several years of "a long and drawn out agony."

In retrospect, it is now very clear that my past diagnoses of the Greek situation have been correct. In this article, I revisit the basic diagnoses, review the current situation, plot out some potential ways forward and make some assessments regarding future prospects for Greece, Europe and global financial markets more generally including US equity market indices such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA).

Understanding the Problem

You can't think intelligently about possible resolutions to the Greek crisis or of future global financial market scenarios if you don't understand the fundamental problem of Greece as it relates to its membership in the Eurozone. If you want to truly understand this problem, I strongly suggest you read an extended essay of mine written in 2010 entitled, "Greece and Germany: Lessons From The History of the Gold Standard." That essay points out that the Euro system is a currency arrangement that is similar to the gold (NYSEARCA:GLD) standard in that it is a fixed exchange rate regime. The essay goes into considerable historical detail regarding the intractable problems with fixed exchange rate regimes such as the gold standard and/or the Euro (NYSEARCA:FXE).

Briefly, the fundamental problem with any fixed exchange rate regime, including the gold standard is this: While a fixed exchange rate regime keeps nominal interest rates fixed, it does not and cannot fix the real exchange rate which is determined by factors such as inflation differentials, productivity growth differentials and terms of trade shocks. In a free-floating exchange rate regime, the economy can adjust to changes in the real exchange rate via adjustment of the nominal exchange rate. In a fixed exchange rate regime, the only adjustment mechanism is wrenching internal deflation and wage deflation in particular. In recent debates regarding the Euro, this option has been dubbed as "internal devaluation."

It is clear that "left" or "progressive" liberal economists, inspired by Keynes's narrative of a "liquidity trap" believe that such a deflationary spiral should be avoided at all costs. It is also well known that Milton Friedman, the great classical liberal economist strongly believed this as well and essentially built his entire "monetarist" economic paradigm upon the premise that central banks could avoid depressions via judicious application of fiscal and especially monetary policy. Specifically, it is well known that Milton Friedman on several occasions predicted the failure of the Euro based on the inability of member nations to use monetary policy to adjust to various types of imbalances and/or shocks - exactly the sort of situation that is currently being experienced in Greece.

Less well known is the fact that Friedrich Hayek, the great "Austrian School" economist in the classical liberal tradition, also believed that governments should actively intervene via monetary and fiscal policy to prevent and/or combat "secondary deflations" - an economic situation described by Hayek that was virtually indistinguishable from Keynes's famous "liquidity trap" scenario. (See here and here among many other possible citations). Hayek was also skeptical that a single currency could work for Europe, for similar reasons as Friedman.

It is, indeed, an extraordinary fact that economists of such disparate theoretical views all came to the same conclusion: All three agreed that in the context of a severe recession, it would be folly for governments to restrain money growth and/or reduce expenditure as this would risk turning a normal recession into a "liquidity trap" or "secondary deflation." Yet despite the clear warnings from economic theory and countless concrete historical examples, the Eurogroup proceeded to implement toward Greece exactly the sort of policies that Keynes, Friedman and Hayek counseled against.

The Theoretical Solution

In this section, I will outline the basic structure of a solution that is fully supported by economic theory and nearly universally supported by competent economists. I will cite Keynes, Friedman and Hayek as representing canonical views within different segments of the economics profession.

1. Fiscal and monetary counter-cyclical expansion. Keynes, Friedman and Hayek were unanimous in their view that faced with a severe recession; a national government should employ countercyclical monetary and fiscal policies to prevent and/or combat a liquidity trap or secondary depression.

2. Flexible currency regime. Keynes was aware of the need for a flexible exchange rate mechanism, and he attempted to incorporate some flexibility in his famous Bancor proposal. However, this ill-fated proposal was not only politically unworkable; it never entirely broke free of the shackles of fixed exchange rate thinking rooted in the gold standard. Friedman and Hayek were actually far more radical than Keynes regarding the need for a total and absolute break from any fixed exchange rate regime, including the total elimination of the gold standard. Indeed, Friedman explicitly predicted that a common currency for Europe would fail - for essentially the same reasons that any fixed exchange rate regime or gold standard would fail. Hayek ostensibly agreed with Friedman on this point. Both Friedman and Hayek believed that in the context of modern economies characterized by a high level of wage rate rigidity, intolerably high unemployment would be the result of any fixed exchange rate regime. They both believed that fixed exchange rates, including the gold standard, could simply not survive the democratic process in the face of such high unemployment. In sum, Keynes, Friedman and Hayek would be unanimous in their view that Greece must unshackle itself from exclusive reliance on the Euro, which is the functional equivalent of a fixed exchange rate regime and/or gold standard.

3. Deep debt-restructuring. Keynes was most famous for proposing aggressive sovereign restructuring in The Economic Consequences of the Peace, passionately warning the Allied Powers against the sort of "Carthaginian peace" imposed on Germany during the Treaty of Versailles. Thus, it is possible that Keynes would have seen the current Greek situation in the same light. Friedman's and Hayek's views are more difficult to discern and would probably be subject to a number of circumstantial nuances. However, they would almost certainly agree that governments should not indiscriminately bail out private actors holding bad debts - as occurred with the bailout of European banks by sovereign governments that purchased this bad debt. Furthermore, it is likely that with respect to sovereign holdings of bad sovereign debt that they would have favored governments "marking to market" any sovereign debts they held, thereby allowing the "market to clear" enabling a maximization of overall welfare. Overall, it seems pretty clear from a theoretical standpoint that debt should be restructured to maximize overall long-term economic welfare and that market prices were probably as good an indicator as any regarding the extent of the sort of haircut required.

4. Structural reform. It is clear to economists on the left and right that without fundamental reforms to the fundamentally dysfunctional Greek economy, characterized by low productivity, the Greek population will remain relatively impoverished.

A Practical Solution

Economic theory may recommend one thing, but politics is the "art of the possible." So, I will briefly lay out a path that is at least possible politically.

1. Parallel currency. Rather than think in terms of an either-or dichotomy that sets up a politically irresolvable stalemate, the EU should allow Greece to issue a free-floating national currency that circulates in parallel with the Euro. The Euro will remain the supreme currency of international trade and finance in Greece as elsewhere in the Eurozone. At the same time, Greece could issue a parallel currency used to partially pay public sector salaries, pensions and other domestic obligations. Such a system of parallel currencies would be compatible in some ways with Hayek's ideas regarding the benefits of competitive currencies. The system would also share features with Keynes's "Bancor" proposal, with the Euro taking the place of Bancor as the international currency in which international trade was transacted.

A parallel national currency along the lines of what I propose would simultaneously achieve three things. First, the Greek government would not have to take on the impossible political task of cutting public sector wages and pensions; it would simply pay these constituencies with a "devaluable" national currency. Second, paying with a "devaluable" currency would amount to the sort of "cuts" in public sector wages and pensions that the Eurogroup has been demanding. Finally, by internally devaluing wages in Euro-terms, Greece would regain international economic competitiveness. Employment would rise in import and export sensitive industries. Furthermore, the emission of a new national currency would generate new source of savings and potential credit that would enable businesses to employ idled labor and other domestic resources.

Currently, Greece is preparing to issue quasi-currency in the form of IOUs to pay for certain domestic obligations. Historical experiences in California, Argentina and other places have been cited as having had some success with such experiments. In my view, rather than resisting this development, the Eurogroup should fully support it as it poses no fundamental threat to the Euro itself. Again, the Euro would remain as the supreme "hard currency" within Greece itself as within all other Euro nations for all international business, including trade and finance. Thus, the Euro would be preserved while allowing Greece some latitude to achieve both fiscal and competitive objectives.

2. Public investment. There is a difference between government consumption and investment, and this difference needs to be discussed in the context of a counter-cyclical fiscal stimulus financee by limited quasi-money emissions. Greece's primary deficit is only around 1% of GDP. Issuance of a new quasi-currency in that amount to finance this gap poses no inflationary threat. Furthermore, Greece could probably afford to issue up to 5%-10% of GDP over a couple of years to finance public investment without creating any rampant inflation measured in terms of the new quasi-currency. This quasi-currency should be used to finance public investment projects that have a high rate of return. It should not be used to create any new permanent public sector employment, as this would run counter to needed structural reform. Expenditure on public investments financed by the new quasi-currency would immediately stimulate the economy while providing a long-term return on investment.

3. GDP-Linked Debt Restructuring. I proposed something along these lines in 2010, in the articles linked above. In the current context, the idea would be to fix debt service as a percent of GDP - allowing debt service of capital and interest to grow as the economy grows and allowing it to fall if and when the economy slips into recession. In my view, this represents the best possible way for Greece to grow and for creditors to maximize sustainable repayment of their credits.

4. Structural reform. Most economists realize that pro-growth structural reforms in areas including labor, business regulation and taxation are the key to Greece's economic future. Greece's economy is dysfunctional in many ways and most Greeks - even within Syriza - understand this. The question is really how to make this actually happen. Acknowledgements and promises have been made in the past, and follow-through has been modest, at best.

In the end, such structural reforms cannot successfully be imposed on Greece in a sustainable fashion from the outside. Structural reforms must come by initiatives of the Greeks themselves or it will not be sustainable at all. The rest of the world needs to be realistic about this. Furthermore, what moral authority does the Eurogroup have as a whole to demand structural reforms when critical reforms have not been implemented in many (if not most) other Euro members?

Tying debt service to GDP aligns the interest of all parties vis-a-vis future growth. This is the only conditionality that foreign creditors can realistically hope to impose on Greece that is actually sustainable.

Future Prospects

While I see my broad set of policy proposals as economically and politically possible, future prospects for implementation are extremely uncertain. The creditor nations have thus far been approaching this crisis as a "morality play" rather than as an exercise in maximizing overall economic welfare. At the same time, the Greek side has been approaching this crisis with an attitude that combines a poisonous mixture of populist "victim's" mentality, righteous arrogance and blatant bad-faith zero-sum tactics inspired by ill-conceived interpretations of "game theory."

The recent resignation of Finance Minister Varoufakis - apparently pushed out by Prime Minister Tsipras - offers some modicum of hope for the future; this removes one important obstacle for constructive negotiations to proceed. Furthermore, Varoufakis's ouster could be a signal that the referendum "victory" of the "no" vote in Greece will not embolden Greece's current leadership to double down on the fundamentally misguided negotiating strategy based on bad-faith zero-sum tactics. What seems clear is that if such tactics continue from the Greek side, Eurogroup leaders are likely to become further alienated, making progress towards a mutually beneficial solution increasingly unlikely.

In terms of the prospects for wider contagion, regardless of the outcome of Greek negotiations, I see few direct threats to the European economy given the fact that private sector exposure to Greece is fairly minimal and even public sector exposures are quite minimal in relation to the size of public sector balance sheets.

I also do not see "political contagion" as a concern, per se. Few nations will want to follow Greece's lead. That is not to say that the Euro might not be challenged in some nations. What I am saying is that any such challenges will be purely domestic in nature rather than being catalyzed by Greece. If anything, the current travails of Greece will serve as a severe cautionary tale.

In terms of financial markets contagion, the Greek crisis could serve as a catalyst to an over-due correction in global risk assets. Such a reaction may already be underway. However, I believe any such correction must be understood in terms of endogenous fundamental and technical factors rather than as a direct result of the Greek crisis.


The fundamental problem with Greece within the Euro is same basic problem that exists with any nation that adopts a fixed exchange rate regime, including gold as money or as a monetary standard: National governments are not able to combat depression and deflation through fiscal expenditure financed with money creation. In the long run, this makes the Euro as economically and politically impractical as is gold money, a gold monetary standard or any other fixed exchange rate standard.

A key lesson of history is that for any monetary regime to be robust, it must be flexible. In this particular context what I mean is that the democratic sovereign must be enabled to directly or indirectly induce an increase in the money supply in order to counter the economically crushing and politically intolerable consequences of what Keynes dubbed as a "liquidity trap" and that F.A. Hayek referred to as a "secondary deflation."

It has become clear that current European institutions simply do not have the policy tools at their disposal - monetary or fiscal - to combat secondary deflations at the national level. As such, the entire Euro arrangement is fundamentally flawed and fragile; its members will not tolerate the arrangement under stress. Indeed, the crisis in Greece is the prototypical test case envisioned by Friedman (and Hayek) in their stated skepticism of the impracticality of a pan-European monetary union.

There are no "good" outcomes to the current predicament faced by Greece and the Euro. However, there are better and worse solutions. Difficult negotiations, including hard-core "bluffs" in the next few days and weeks may temporarily spook financial markets that have not thoroughly digested all of the potential scenarios and consequences of a protracted Greek crisis. The only good news for global markets is that, once markets process all of the possibilities, the ultimate verdict is likely to reflect the fact that Greece simply does not directly or indirectly matter very much to overall European or global financial markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.