The Nitty Gritty on How and Why Greece Will Leave the Eurozone

Note from author: This post is a special members-length weekly (for Credit Writedowns) that I am making public because it is a continuation of the ideas for a Greek exit for the euro zone that I published on Friday. This post, however, also incorporates specifics that Marshall Auerback has laid out in a separate post and demonstrates why exit is the likely option.

Now, the Greek exit scenario I outlined on Friday is identical to the one I proposed in November for Italy when serious policy makers were toying with the idea of letting Italy enter a Greek-style death spiral. In Italy’s case, the country is too big to fail. Anyone who has tried running through Italian default scenarios understands immediately that Italian default equals a global Depression. This is why questioning Italy’s solvency leads inevitably to monetisation. The ECB has now stepped in and monetised the debt and will continue to do so.

Before we continue to Greece, I do want to flag something about the Italian situation that I wrote when explaining the monetisation route we are on in November.

Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.

As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.

That last bolded sentence is the key one. It tells you that Italy’s is a question not just of liquidity but solvency as well. For the time being, the solvency issue has been laid to rest by the ECB’s intervention. However, the euro zone is on a very pro-cyclical fiscal course. And this decreases GDP without any obvious growth offset, meaning that deficits will continue and Italy’s debt burden will grow under the current EU policy framework. It is highly likely that the solvency question for Italy will again become acute very soon.

It was refreshing to see Wolfgang Münchau reach similar conclusions in his recent piece in the Financial Times. He writes:

For argument’s sake, let us assume that Mr Samaras will stick to the programme and that a debt trap can be avoided. Everything works as officially planned. Would that be the end of the Greek crisis? In that case the Greek debt-to-GDP ratio would fall from over 160 per cent today to about 120 per cent of GDP by the end of the decade.

But this will still be far too much. We should remember that 120 per cent is a political number that lacks economic justification. It is no coincidence that this happens to be the current Italian debt-to-GDP ratio. If one admitted that 120 per cent was not sustainable for Greece, one might create a presumption that the same was true for Italy. (See: "Why Greece and Portugal ought to go bankrupt).

However, Wolfgang’s conclusion from this is the same as mine: Greece and Italy are different. Italy is a country with a primary surplus and a dynamic export base. It has a real shot at reducing its government debt levels in a less pro-cyclical fiscal environment. On the other hand, Greece not only lacks basic economic infrastructure on things like taxation to raise the revenue that would reduce the debt quickly, unlike Italy, Greece has been running a primary budget deficit across the business cycle. It is clear to everyone then that cutting expenditure and raising revenue poses a real challenge that Greece cannot meet. In Greece’s case 120% debt to GDP is still too high. Wolfgang concludes that a cut to 60% of GDP in the case of Greece (and Portugal) is the only way to give them a fighting chance. He says do it now because waiting two years would be "ruinous" as the riot scenes in Greece right now make clear.