Today's Financial Thermopylae Beckons-----But Don't Count On The Greeks

The global financial system desperately needs a big, bloody sovereign default----a profoundly disruptive financial event capable of shattering the current rotten regime of bank bailouts and central bank financial repression. Needless to say, Greece is just the ticket: A default on its crushing debt and exit from the Euro would stick a fork in it like no other.

But don't count on the Greeks. Yes, their new government does have a strong mandate to throw off the yoke of its Brussels imposed bailout and associated debt servitude. Were the Syriza government to remain faithful to the raison d'etre of its wholly accidental rise to power, the task of busting the misbegotten euro project would be its own special form of god's work.

But notwithstanding Tsipras' resolute speeches (“We will not accept psychological blackmail") and Varoufakis' elaborate game theory maneuvering and hair-splitting word games, the odds are against a regime-shattering "grexit" event in the immediate future. If it does happen, it will be the result of  political miscalculation among the parties, not the policy agenda and will of the new Greek government.

The problem is that to the extent that Syriza has a coherent program----and that's debatable----it amounts to a left-wing Keynesian smorgasbord that will eventually drive the Greeks to clutch at any fig leaf of compromise which enables them to stay in the Euro. Unlike the Germans, Varoufakis & Co have no scruples whatsoever about central bank financing of state debts, and see the ECB as the ready-made agent of just that form of financial salvation----for themselves and the rest of Europe, too.

So notwithstanding the current fevered tensions between Greece and its paymasters, nearly every issue of difference between them can be finessed---that is, given enough double talk, weasel words and kick-the-can windage. Certainly wordsmiths in the wee hours of the morning can find phraseology that bridges the difference between an "extension of the current program", as insisted upon by the Germans, and the Greeks' most recent proposal to "proceed jointly to a successful conclusion of the present arrangements".

Even on core substantive issues like the size of the required primary budget surplus, the target number of state employees, minimum pensions for citizens with minimum incomes, the precise slate and schedule of the state properties to be privatized -----all can be worked out during showdown negotiations. After all, these issues are all about splitting numbers and fudging timelines------the very thing that politicians were created to accomplish.

But what can't be compromised is the one thing that ultimately counts. Namely, a substantial default on the nominal level of Greece's staggering debts.

On that score, the EU politicians and bailout apparatchiks have taken themselves hostage. Not a single government outside of Greece could tolerate a capital call to make good on their bailout fund guarantees. That would fatally embarrass Mrs. Merkel, cause the fall of the French and Italian governments, leave financial cripples like Spain, Portugal and Ireland rampaging for relief and bring populist radicals out of the political woodwork from one end of Europe to the other. In short, to save the euro from the purported "contagion" effects of sovereign defaults, the geniuses in Brussels have effectively strapped political time bombs to their collective chest. The Greek debt guarantees are promises that dare not be activated.

Yet.....yet------Herr Schaeuble need not frown so much. Syriza's chief financial brain trust, Yanis Varoufakis, takes his lead from Professor James Galbraith-----a second generation, unreconstructed Keynesian statist who never saw an economy that couldn't be inflated to the pink of health through prodigious monetary and fiscal injections. Accordingly, the last thing the Greek government wants to do is stage a jail break from the Euro and/or welch on its debts to the EU, ECB and IMF.

Varoufakis made all this clear more than a week ago at the get-go of his European grand tour:

Attempting to sound an emollient note, Mr. Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

Smart debt engineering! Why that sounds like he's channeling Barrack Obama----and doing so in a manner that is too clever by half.

Varoufakis' debt relief schemes boil down to nothing more than a prosaic exercise in present value economics----something you learn about in Economics 101. So, yes, give Greece a five-year grace period on payments of principal and interest on the approximate $270 billion it owes the EFSF, ECB and IMF; cut the weighted average interest rate on this debt from an already negligible 1.8% even further toward the zero bound or swap some of the principal for variable rate GDP performance bonds; and go back to the Versailles precedent on maturities and stretch them for 50 years until 2065. Do all that----and you will have whacked the NPV of the debt by half or more.

But that wouldn't solve the problem and, in fact, would amount to the ultimate betrayal of the Greek people.The latter can never, ever regain their democratic sovereignty or sustainably rebuild their domestic economy and international credit unless a vast amount of the contractual principle owed to the European superstate and IMF is flat-out extinguished, cancelled, repudiated.

Here's why. The world will not remain enthrall to the ZIRP deformation of Keynesian central banking much longer; and certainly not for the decades over which the Varoufakis' NPV game would stretch the Greek maturities.

Instead, interest rates on sovereign debt will presently normalize, and violently so in the case of states which cannot govern themselves fiscally. There are demons that dwell in the terra incognito beyond ZIRP, and they will eventually reveal themselves to be nothing more than the bond vigilantes of yore.

That means the "roll-over" risk embedded in the Greek state's crushing debt load is insuperable. If Greece doesn't default now on debts which extract 3.0% of GDP in interest costs, it will surely default later when interest expense rolls-over at double, triple, or event quintuple the current tab. And whether the default comes sooner or later, an economy perpetually on the edge of state bankruptcy will not escape the grinding austerity and deprivation now afflicting the Greek people.

The only way around that arithmetic certainty is via delusional resort to the Keynesian version of Art Laffer's napkin. That is, the notion that Greece can grow out from under its crushing debt via decades of robust GDP expansion. But at least Laffer was directionally correct: Lower taxes alone will not balance the budget, but they can at least remove some of the state's tax barrier to growth and entrepreneurial wealth creation.

By contrast, the Syriza program amounts to the opposite of supply side. Namely, a vast expansion of the state through large scale public investment and the preservation of inefficient public monopolies and underpriced public services. This statist core is then augmented politically by clobbering the oligarchs with their fair share of the taxes and fiscal sacrifices.

Good on them for the latter, yet putting the oligarchs in the public stocks will only help with equity and justice, not economic growth and productive investment. In fact, the Syriza variant of Keynesian statism is virtually guaranteed to keep Greece in state debt bondage as far as the eye can see.

The reason is that the core Syriza program of massive public investment in infrastructure, housing, schools and social services flat-out precludes a primary fiscal surplus. Any paper commitments it may make as part of a compromise "re-set" of the Brussels program are sure to be window dressing---gist for the Troika's rechristened successor to importune Athens about "compliance" with any new deal.

To be sure, the Germans are being utterly predatory in their insistence that Greece should carry the full cost of bailing out the German and French banks. But at least they've got the math right. Without large primary surpluses for decades to come, Greece will never escape the "debt trap" in which it is currently impaled.

The truth is, the Jamie Galbraith/Paul Krugman version of "public investment" advocated by the Greek government involves a fatal disconnect. These Keynesian yarn-spinners have never even remotely demonstrated that a country already saturated with subways, stadiums, highways and airports can levitate economic growth by redistributing income from taxpayers to the public fisc. But when you crank up public investment and run a primary surplus at the same time----as Syriza notionally proposes--- the only thing you get is redistribution of the current economic pie. And if you fund roads and bridges you don't need with taxes on private savings and investment, you eventually trigger an erosion of efficiency and productivity, not sustainable growth and jobs.

Then again, the Keynesians know that all too well. That's why "public investment" in their vocabulary is just a code word for deficit financed public spending. And any spending sponsored by the state's politicians and bureaucrats will do-----even on pyramids or digging holes and refilling them. Its all about an economic abstraction and model component called "aggregate demand". Growth purportedly comes from dollars spent, not efficiencies garnered and productivity earned.

But here's the thing. When an economy reaches the condition of "peak debt"----which Greece surely has----the Keynesian parlor trick of debt financed spending not only looses its efficacy entirely, but is no longer even possible. Capital markets---even our drastically impaired ones-----will not provide incremental lending without sovereign guarantees; and no state will be credible in underwriting such advances unless it has the fiscal strength and rectitude of Germany.

So at the end of the day the Syriza plan is a circular path to permanent stagnation and endless conflict with its superstate paymasters. An 11th hour prolongation of the status quo based on word-splitting, a dollop of new cash and an endless future of renegotiations will accomplish nothing-----except to provide the world's speculators and robo-traders a few more weeks or months of lucrative play time in the casino.

Needless to say, there is a far better alternative----a Plan B that could actually provide the Greek people surcease from their trauma. The heart of the matter is not the fact of austerity, but the ends that it serves and the manner in which it is imposed.

To wit, the Greek people must endure many more years of fiscal belt-tightening, but not in order to make the foolish Eurozone governments whole on the money they spent to bailout their own banks. Instead, the purpose of the new Greek fiscal austerity would be to earn back its credit in the global capital markets, not the political puzzle palaces of Brussels, Berlin, Paris and Rome.

During that credit recovery phase, the Greek state would have no ability to borrow, period. After decades of fiscal profligacy it would have to live within it means each and every year. Its politicians would have to make tough choices and establish social priorities. If the voters want more socialism and redistribution that would immediately feedback in the form of lower investment, growth and government revenues, and more fiscal belt-tightening for all.

Historical Data Chart

"Austerity" of this kind would not only serve the right purpose, but would also be attained through the the right process. Namely, it would be the product of Greek democracy and local self-determination, not the officious writ of traveling plenipotentiaries from a distant superstate and its unaccountable officialdom.

Stated differently, if the Greek people truly want to rid themselves of the hated Troika, they need to default on the debts that were imposed and enforced by the latter. While they are at it, they might gain a measure of succor for their travails since 2010 by arresting any Troika official who dares return. The truth is, fiscal austerity in a democracy can only be imposed by a government the people have actually elected.

Yes, defaulting on the Eurozone/ECB/IMF debts would force Greece to run its own central bank and manage its own currency. But this would be a boon, not a burden------and not because it would allow Greece to depreciate its way back to prosperity.

Given all that has gone before and a default on the claims of its superstate paymasters, Greece could never bring back the old drachma and a central bank printing press. To do so would be to invite instant massive currency depreciation, capital flight and a gale of crushing inflation on the 25% of GDP that it currently imports. Nary a BMW or Opel dealership would be left standing---to say nothing of the imported fuel needed for the cars and imported food needed for their drivers.

Instead, Greece could only launch a New Drachma if its central bank were completely forbidden to buy Greek state debt. That is, ironically, it would need to embrace the German monetary catechism in full.

Indeed, rather than print drachma liabilities out of thin air in the style of the ECB and Fed, the post-liberation Greek state would need to do the opposite. Namely, acquire "hard" international assets such as dollars, RMB and gold to provide a convertible backing for its New Drachmas. Such an arrangement would insure stable purchasing power for its currency, but leave its reconstituted money and capital markets free to discover honest prices for Greece's public and private debt, alike----and any other tradable security, as well.

In short, a default and grexit would reintroduce Greece to a world of honest money, fiscal discipline and genuine democratic self-government. In that context, the Greek economy might or might not start growing again. That would depend upon whether the electorate voted to continue the numbing statism of the Syriza program or opted for a policy regime more friendly to investors, entrepreneurs and the aspirations of ordinary workers and citizens to improve their own economic circumstances.

But the saving point is this. A post-default Greece would not have to grow for the sake of being a  beast of burden for the taxpayers of northern Europe. Its state balance sheet would be clean------so if the Greek demos opted for a life of socialist penury, it would have every right and opportunity to do so.

Needless to say, a default and "grexit" would radically transform European politics and economic life. It would cause a rapid dissolution of the superstate monstrosity known as the EU--- along with the demise of its leading institutions, most especially the ECB. So doing, Europe would get back on the right side of history.

If the world is to have capitalist prosperity and democratic self-government, it needs smaller more personal states and big, anonymous markets. Only in the latter can "price discovery" be honestly conducted by the unseen hand of millions of savers, investors, issuers and speculators; and winners and losers be determined by the verdict of the marketplace, not the machinations of state politicians and apparatchiks.

If Europe's current statist calamity proves anything----it is that the superstate governance model and central bank dominance of financial markets is all wrong. And if the Greeks really want to regain their liberty and a chance at capitalist prosperity, they must step onto the euro/EU exist ramp forthwith-----doing god's work of extinguishing the latter as they go.

Nor should they hesitate to look back for fear that their economy will turn to a pillar of stone----owing to capital flight and a run on their banks---- during the transition. The Greek banking system has something in the order of $140 billion in deposits left. To bottle those up for a few weeks or so------the Greek authorities would only need to take a leaf from the only sensible thing FDR did during the 1933 crisis.

Namely, nationalize the big four Greek banks, which are cesspools  of insolvency, corruption and oligarch thievery anyway, and quickly re-open them when the New Drachma regime is launched, but only after a massive write-down of impaired assets. Yes, holders of their stock and notes would be wiped out, but that would be condign justice in any event.

As for everyday deposit holders, the government would have to guarantee some substantial portion of the $140 billion. It would become an obligation of the state to be paid-off over time from the surpluses of self-imposed austerity. As for interim hand-to-hand currency for depositors not inclined to embrace the state's guarantee, FDR had a solution for that, too.

Back then they called it bank script. Today the Greek national bank still has its euro engraving plates. If it creates some euro script during the transition, even the Germans would not be crazy enough to send their Army back----72 years later---- to confiscate it.

Yes, the transition would be messy, but not nearly so much as the alternative. Namely, debt servitude, economic stagnation and loss of sovereignty as far as the eye can see.




David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.

Get Access