Thursday, May 26, 2011

Feldstein: Greek Default Inevitable

Harvard University George F. Baker Professor of Economics and National Bureau of Economic Research President Emeritus, Martin Feldstein, explains in a new paper why a Greek default is inevitable:
The Greek government, the European Commission, and the International Monetary Fund are all denying what markets perceive clearly: Greece will eventually default on its debts to its private and public creditors. The politicians prefer to postpone the inevitable by putting public money where private money will no longer go, because doing so allows creditors to maintain the fiction that the accounting value of the Greek bonds that they hold need not be reduced. That, in turn, avoids triggering requirements of more bank capital.

But, even though the additional loans that Greece will soon receive from the European Union and the IMF carry low interest rates, the level of Greek debt will rise rapidly to unsustainable levels. That’s why market interest rates on privately held Greek bonds and prices for credit-default swaps indicate that a massive default is coming.
Feldstein nails the problem, but he then goes on to raise concern about a supposed trade-deficit Greece would face:
But fiscal sustainability is no cure for Greece’s chronically large trade deficit. Greece’s imports now exceed its exports by more than 4% of its GDP, the largest trade deficit among eurozone member countries. If that trade gap persists, Greece will have to borrow the full amount from foreign lenders every year in the future, even if the post-default budget deficits could be financed by borrowing at home.
Feldstein here takes the view (implied) that government must have a major role in the Greek economy. Without this implication, there would be no problem. Since any financing by foreigners would have to be at the corporate or individual level, where a foreigner is likely to look at the creditor much more closely than if the creditor is the government (aside from the issue of the willingness, or unwillingness, of foreigners to buy Greek government debt, just after a default).

The key to a successful Greek government default rests on the relationship of the government to the economy. If the government continues to play a major role in the economy, supporting huge sectors of the economy, then the default will only result in a further crisis down the road.

A successful default must include a change in the relationship between the government and the economy, whereby the role of government is extremely limited and the Greeks simply find their own way via the free market. It is the only way to create a prosperous country with a growing standard of living.

Feldstein recognizes (again implied) that a large role for the government can not go on after a default, with the current structure of the economy. But amazingly instead of calling for a move toward free markets. He calls for:
A temporary leave of absence from the eurozone would allow Greece to achieve a price-level decline relative to other eurozone countries, and would make it easier to adjust the relative price level if Greek wages cannot be limited. The Maastricht treaty explicitly prohibits a eurozone country from leaving the euro, but says nothing about a temporary leave of absence (and therefore doesn’t prohibit one). It is time for Greece, other eurozone members, and the European Commission to start thinking seriously about that option
I have no objection to the Greeks leaving the eurozone, but Feldstein is not showing all his cards in his call for a Greek move out of the zone. The key to Feldstein's thinking is his discussion of relative prices. What he wants the Greeks to do is return to the drachma and then destroy the value of the drachma via money printing, as a way to improve the trade balance. This is simply mad mercantilist thinking, that will ultimately lead to further destruction, through currency depreciation, of the Greek economy.

The degree that elitists hate free markets is astonishing. They will call for almost any destructive scheme rather letting markets work. Feldstein displays that attitude in his refusal to consider a move toward free markets as an option for the Greeks.

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