Greece is Not a Threat to the Eurozone

Negotiating is a good thing. If you do not, then you never get what you deserve. But you need to be realistic about your strengths and how you go about doing it. In the case of Greece there is a popular claim that Greece represents a threat to the European and the worldwide economy. This is the card that the Greek government is playing in order to force other European countries to provide a different deal on the country’s debt and the measures that need to be implemented as part of reform efforts. The argument goes that if Greece defaults and exits the Eurozone then other countries might do so as well. That would be an economic disaster indeed, as the Euro-experiment would be most likely dead.

However, just yesterday, I had a discussion with a senior executive from one of the largest banks of the Western world. I asked him what would be the effect on the bank from a potential Greek exit from the euro. His response was “we would not even blink. Minimal.” I happen to agree with his assessment more broadly as I study the data and analyze the balance sheets of banks around the world.

Greece exiting the Eurozone was a very costly outcome up until 2012 and maybe 2013. But it is not anymore as other countries have implemented reforms and have already gotten out of recession. The data is clear. Up until 2013 yields of Italian, Portuguese and Spanish (IPS) government bonds exhibited a strong positive correlation with the yields of Greek government bonds. Using monthly data those correlations were extremely high, in many cases close to 0.8 or 0.9. The price of Greek government bonds went up, so did the price of IPS bonds. The price of Greek government bonds went down, so did the price of IPS bonds. Effectively what this meant was that investor perceptions about the probability of default of these governments were moving uniformly across all these countries. When investors perceived Greece to be more likely to default they also perceived Italy, Portugal and Spain more likely to do so.

This has changed profoundly in the last year. These correlations were close to zero in 2014 and have turned negative in 2015. Let me make this clear: an increase in the probability of Greek default is not associated any more with an increase in the probability of default by Italy, Portugal, or Spain. As you can see quite the opposite (blue line is the evolution of the yield on the 10-year Greek government bond starting from zero; purple line is on the 10-year Portuguese government bond. During the last year the former has increased by 50% relative to its value a year ago while the latter has decreased by 50% using Bloomberg data). As the probability of Greek default increases, the probability of a Portuguese default declines.

Source: https://www.bloomberg.com/quote/GGGB10YR:IND

What is equally interesting is the fact that yields on IPS government bonds now exhibit an extremely high positive correlation with German government bonds. These correlations in 2014 were close to 0.99. Yields on German and IPS bonds are all declining while interest rates on Greek bonds are increasing.

Greece needs a new approach. To get something you have to give something. But in this case you could have a win-win situation if you maximize the gains from trade. So here is my proposal: the highest gains from trade would be for Greece to negotiate and get approval from its creditors to lower and stabilize tax rates on various economic assets and activities, especially on taxes that affect the lower and middle income households. That would give Greeks more money to repay their debts, consume, or invest for the future and restart the economy. The sharp increase in taxation has devastated the economy and this needs to stop.

In exchange, Greece should commit to accelerate the reforms that would increase the effectiveness of the public sector, remove labor market dysfunctions and the barriers to product market competition. These reforms could accelerate economic growth. And if that is not enough to satisfy the creditors then also tax the very rich of the country that have been long evading paying their fair share.

The good news is that this all makes economic sense. The problem is that it does not make political sense.