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Economist Mark Blyth: Continued Austerity Will Be Catastrophic for Greece and Europe

Economist Mark Blyth analyzes the potential impact on Greece and Europe of the game of chicken between Syriza and the European Central Bank.

Unless Syriza goes in with an absolute poker face and can convince the people on the other side of the table "we're willing to take these risks come what may," then they might as well forget about negotiating anything. (Photo: MB-E)

This interview was conducted in late January 2015 and remains relevant because it reflects Mark Blyth’s views regarding Syriza’s positions, how Syriza should respond to the demands of the troika and what other options might exist for Greece, including a possible “Grexit.”

Michael Nevradakis: All eyes have been on the Greek elections and on the victory of Syriza in the polls . . . in your view, what does Syriza’s victory mean for Greece and for Europe?

Mark Blyth: It could mean many things. It also depends on what Mario Draghi is going to do, so let me talk about the two of them linked together. So imagine all the people who have been standing on the sidelines, like me and many others, pointing out that the reason that the crisis that ran from 2010 to 2012 seemed to have ended was because the European Central Bank [ECB] flooded the market with liquidity. They chalked basically two trillion euros of cash at the banks in a program called the LTRO [longer-term refinancing operation]. So basically, chalked two trillion, and this basically allowed local banks, from Greece to Spain, to buy local bonds, drag the yields down, and recapitalize the banking system. So hurray for that, three cheers for Mario. So apart from that, they’ve continued to tighten. That is to say, austerity has continued, as Greece knows only too well. And the cost of this has been continued economic stagnation and downright depression.

Now, when you get to this state, the problem is, either way, the real economy – and you are now facing what is called deflation, continuously falling prices, rather than inflation. So Mario says, “Okay, we’ve now got to have an accommodating fiscal policy; governments have got to do something as well as the central bank.” But the governments have resolutely refused to do so and continued to tighten against all evidence to the contrary. So Mario’s last trick is this thing called quantitative easing. So he’s going to actually buy government debt, perhaps, or maybe the local central banks will do it, or maybe they’ll do it in some kind of attenuated way, but that’s the gig. The Americans have done it; the Brits have done it – and it seems to work; so it’s the last big arrow in the central bank’s arsenal.

Now let’s suppose he does it. The markets rally, everybody’s happy, the Germans are upset, but everybody else thinks it means the eurozone’s going to finally stop deflating and start growing. This means something for Syriza, because they’re going to be in a position whereby the expectations for growth in the European economy and in Greece are going to be heightened. So their arguments for debt forgiveness, renegotiation of terms, etc. are going to fall both on more sympathetic ears on the one side, because basically there’s a kind of tacit acceptance that “yeah, you guys are right, what we’ve been doing is economically suicidal, let’s stop,” but it’s also going to be tough for them to argue for it, because people are going to say “Hey, now you’ve got QE, why don’t you just stay the course? Because things are ultimately going to work out.” So what happens in terms of what the choices [are] between the EU, the Germans, the troika, the incoming Greek government, all of that depends on what Mario does first.

How does Syriza’s victory impact other countries in Europe, as well? We’ve seen, for instance, the tremendous rise of Podemos in Spain, another country that has experienced crisis over the past few years. What impact might we see there, but also in Northern Europe, in Germany and in some other countries where we’ve even seen eurosceptic parties on the rise recently.

Definitely. So, very very strong interlinkages, both in the political and in the economic. Let me start with the economic and go to the political. So let’s suppose that Mario doesn’t get to do QE. The markets are disappointed; the Germans are pleased because it means that Weimar will never happen again – even if it means that Europe falls off a cliff economically. So, all of this continues. What happens next?

Well, then the Greeks demand renegotiation of the debt; they threaten default. The Germans say, “We don’t care this time, because ultimately we’ve got firewalls; we know what’s on the banks’ balance sheets.” If Greek assets go to zero, it doesn’t necessarily foreshadow a contagion run, whereby because a bank loses money on Greek assets, it sells Portuguese assets; then it sells Irish assets, and that was the big fear last time, hence everyone was talking about PIIGS and Gypsies being in it together. And they’re saying “No! We’ve got the firewalls up; we’ve got the bulkheads now; we know what’s on the balance sheets; the Greek assets are isolated. If Greece throws itself out of the euro, well to hell with Greece; they’ll pay the price; we’ll all be fine.” I’m not so sure.

First of all, you can expect them to say that. Remember the Lehman crisis? The way that that crisis happened wasn’t because of the assets on Lehman’s books directly. It was because of the interaction around the market called the credit default swap market. These derivative contracts, kind of third-party insurance policies that people were writing on each other, and that big company called AIG, that was the counterparty to all of this stuff. That’s where the crisis really emerged: it was these hidden interlinkages. I also know for a fact that banks tend to understate the riskiest assets. Why? Because the risk is where the money is. So you want to basically arrange your balance sheet in such a way that it looks like it’s a lot safer than it actually is. Now I don’t know that for a fact in the case of discrete banks, but, in principle, we know that banks tend to do this.

After the fact, we find that the exposures are always larger than we thought before. So given all of this, I think that the real risk is there’s all these hidden interlinkages, and if Greece actually exits or is forced out, then there’s going to be contagion and then there’s going to be trouble for the euro, despite what the Germans say.

Now let’s link this back to the politics for a second. Absolutely there’s a demonstration effect. Here’s the one that Syriza is saying, which is entirely plausible when you consider the experience of Argentina in 2001.

Argentina defaulted on its debt; everyone said they would die. They’ve done it before, look, it’s the Argentines, they’re always up to this kind of caper; well they’ll pay the price this time because they’ll be locked out of market access. Well, in actual fact what happened was they put up capital controls, and then they grew up at 7 percent a year for four years.

Now the Argentines, of course, managed to squander that because of the bad governance institutions, which is something which may still happen in Greece as well, let’s not discount that, but nonetheless, they grew. And the demonstration effect of Greece leaving and actually not completely imploding would really put a spike into the politics of Spain and Podemos, and also empower the euroskeptic northern parties, which tend to be more on the right.

Ultimately, this goes back to an old saying: You can’t run a gold standard in a democracy. Europe has been trying to run that type of monetary regime, a hard money machine without exits, for the past seven years. The result has been the recession, as the unemployed in Greece know so well. The idea that people are going to vote for this indefinitely is clearly nonsense. So we may begin to see the first cracks in this in the coming months through Syriza and then its knock-on effects.

Do you believe that the economic platform that Syriza has presented, which promises to roll back many of the cuts and the austerity measures of the past six-plus years and to renegotiate Greece’s debt burden and the terms of its agreements with Europe and troika, do you believe that this platform is viable to begin with, and do you believe that European officials and the so-called troika will budge?

They’re related, but they’re separate issues. Will they budge? It depends on what they believe the damage will be to not budging. So that relates to what we were talking about, hidden interlinkages, risk in the banking system, etc. Basically, Greece has to threaten the stability of the euro to get what they want. Now let’s say that they get what they want, let’s start with the issue of how you get out of a debt crisis. Well, in the financial press, you get this line all the time that says, “Oh my goodness, Greek debt to GDP is 176 percent or 178 or 179 percent, and their growth rate is terrible; the demographics are awful; they’ll never pay that back.” That’s not news; everybody knows this.

And unless Syriza goes in with an absolute poker face and can convince the people on the other side of the table “we’re willing to take these risks come what may,” then they might as well forget about negotiating anything, because unless that’s credible, they’re going to get nothing.

The question is then, how do you deal with this? And so far, we’ve been dealing; the way that banks call it is “extend and pretend.” I will continue to extend to you lines of credit, and you will pretend that eventually you will pay me back. Eventually this has to stop. No debt renegotiation settlement or other way out of a debt crisis has ever been possible unless forgiveness is on the table, that some of it has been written off, and there are further haircuts, which are slightly below forgiveness, so they’ll get something back; and then there are solutions which are called Brady bonds, which were invented in the Latin American debt crisis of the 1980s, where basically you create a second class of defaulted bonds, and then you have a secondary market on those, on the hope that they will redeem some value over time. So some combination of those things is what any sensible renegotiation would have.

Can Syriza get some of that? It depends on what happens. If the Germans and the ECB and the troika credibly think that the demonstration effect of doing this and the risk is very, very high, that is they’ll have to do it elsewhere, and then at the same time that the risk of the banking system of Greece getting out is low, then they’re going to play hardball and they’re not going to get it. That then leaves Syriza in a difficult position. Do they basically say, “We’re out, to hell with you” and bear the consequences? So it is in classic terms a game of chicken, two cars running at each other, which car is going to be the first one to turn.

Now in terms of rolling back austerity, that depends on the budgetary position of the government. If they have their own currency, that will be a lot easier to do. If you’re doing this in the context of the euro, you can certainly squeeze less, but as for the idea that you’re going to increase the minimum wage and restore benefits to where they were before, that could be harder to achieve than simply getting the renegotiations on the table.

Building on this last point, do you believe that Syriza should at least entertain the possibility of a Greek departure from the eurozone, at the very least as a negotiation tool or even as a “plan B,” if it is unable to accomplish the change that it has promised within the eurozone mechanisms.

Well if it doesn’t credibly signal that that’s the way that it’s behaving, then it wouldn’t get anything. So ultimately you have to go into this with, “We’re prepared to leave, and we really do believe we can survive.”

Now what would happen if Greece went out? Let’s forget about the contagion to everybody else and the banking system. What happens in Greece? Well you’ve got a really difficult type of technical problem here when you’re in a monetary union, when you’ve actually banned your own currency. Let’s go back to the Argentine example. So the Argentines had a dollar peg, so they were basically keeping their exchange rate pegged to the dollar. And when that peg broke because it became too uncomfortable for them and basically because currency values were going down and they had debt repayment issues, similar sort of story, they still had their own currency in their ATMs and in everybody’s wallet. But in Greece, you don’t. So there’s a very high transactions cost problem, because what you’ve got to do is, basically, on a Friday night, convince everyone that everything’s fine, and then certainly you’ve managed to convince the Swiss or someone to print your whole new currency and nobody’s heard about it. That then flies into Athens on a couple of planes and then fleets of armored cars go out everywhere in Greece and stuff the ATMs, and nobody figures out anything’s going on; nobody leaks it; no bank clerk notices.

You then have a bank holiday on Monday to make sure that everything’s fine, and then you open up the banks on Tuesday and then you say, “Ta-Da! new currency,” and then you’re out of the euro. That’s not going to happen. It’s going to be extremely messy and difficult to do this.

Now let’s say that you get past the first part, the messy and difficult part, then what happens? You’ve got a huge fall in your exchange rate. This is really good, traditionally speaking, in terms that you’ll be able to export more. But the problem with the Greek economy is that, like many of the periphery economies, a lot of what it exported disappeared because it began to specialize in basically tourism and a few other things. This is the Spanish case with the real estate building; the Greek economy is still heavily dependent on tourism. So in a sense, you can bring in people to come and have vacations with you and then pay even less but hope for more volume. That’s not going to pick up the whole economy.

The other side of this: Your imports are going to get hugely expensive. Now imports have already collapsed after five years of austerity, so it’s a question of how much that bites. But it will lead to an inflationary effect, plus the fact that your currency is worth less, you’ll need to print more of it to buy the same amount of stuff. So rather than the rest of Europe having a deflationary problem, very quickly Greece could have an inflationary problem, and then that’s got ramifications for investment and so on and so forth.

But let’s suppose that all of this stabilizes. At the end of the day, these are all classic Donald Rumsfeld “unknown unknowns.” And unless Syriza goes in with an absolute poker face and can convince the people on the other side of the table, “We’re willing to take these risks come what may,” then they might as well forget about negotiating anything, because unless that’s credible, they’re going to get nothing.

There have been conflicting statements from German and EU officials regarding whether there is even a mechanism for a country to depart from the eurozone or not. What actually is applicable in this case?

That’s a really good question! You’ve got to remember the history of the euro. The euro wasn’t meant to be an end point; it was meant to be a starting point; it was the starting point of a political union. But basically, everybody got the benefits of having one currency in the midst of a global credit bubble, and everybody basically ignored the fact that you needed proper banking regulation, and you needed to watch cross-border liabilities in the banking system, and you needed a financial union and a banking union and ultimately a political union.

But at the end of the day, the mechanism is quite simple: I refuse to pay my debt. If you refuse to pay your debt you go bankrupt. At that point in time, the ECB can either bankroll you or it can cut you off.

So when the crisis hit, you have the EU region’s largest economy, 3.8 trillion dollars or euros, and then you’ve got the eurozone as a whole, at about 15 trillion, the largest one being Germany, of course, and then you have the assets of the banking system, which are impaired liabilities in many cases, at about 45 trillion. So the Germans look at this and go, “That’s 12 times our GDP; I’m not touching that with a barge pole,” hence their reticence to get on the hook for anybody else’s debt. You don’t have your own currency, so you can’t inflate your way out of trouble, and you can’t devalue your way out of trouble, so you’re left with “squeeze, squeeze, add liquidity, and pray,” which is where we’ve been for the past seven years.

Now, given all of this . . . there’s article 125, article 123, all this sort of stuff in terms of the legal basis, but at the end of the day, the mechanism is quite simple: I refuse to pay my debt. If you refuse to pay your debt, you go bankrupt. At that point in time, the ECB can either bankroll you or it can cut you off. If it cuts you off, de facto you’re out of the euro. You don’t have to worry about treaties. It’s much more effectively done that way. So yes, there are legal niceties if you want to start to get into how you can do an orderly default and so on and so forth, but again, to go back to the credibility story, these guys really are serious. Syriza shouldn’t be worried about an orderly default if it decides to leave. It should basically be worried about convincing the other guy you’re going to cause them maximum pain and discomfort, which will bring them back to the table to give them some of what they want so that they stay in.

How have the international bond markets reacted to the elections and to Syriza’s victory?

Well there’s been a little bit of a spike, as a rise in the interest rates paid on bonds, but if you compare it to the position it was in by 2010, 2011, it’s not even close. Now, why is this? Again, it goes back to the following story. As I said on many occasions before, you’re in a single currency; you have a problem with your banking system. The largest economy is too small to bail out the collective liabilities. And then, you can’t devalue; you can’t inflate; so you’re left with squeeze out liquidity and pray. So in 2012, Mario Draghi added liquidity and he gave us a promise: “I will do whatever it takes to save the euro,” and this thing called optimal or outright monetary transactions, bond-buying basically, as a promise if needed, and the yields went down.

Now, having done that, the markets believed that the ECB, irrespective of what the Germans or anyone else thinks, will do what it needs to do to save the euro. So that means the following: Even if Syriza comes in, yes there will be a spike; yes there will be capital flights; you’d expect investors to protect their assets and so on and so forth. But they really believe at this point that the ECB will sort it out. One way or another, there will not be a default. Now, the minute that credibility evaporates, then there’s a problem. And that’s why if Draghi doesn’t get to do QE, now the whole world and their grandmother is expecting it, then that means that that will be priced into the results of the Greek elections, and you can see much higher yields if there is no QE program.

In your book, Austerity: The History of a Dangerous Idea, the Greek version of which was recently released in Greece, you discuss and analyze why austerity has not worked and why it does not work as an economic policy. Could you summarize some of the key reasons why austerity is, in your view, not good economic policy?

Sure. If you look at the positive cases where this has worked, it’s a bunch of small countries in the 1980s, Denmark, Canada, Sweden to a certain extent. And what did they do? Well, they cut. And when they cut government spending, the economy got better. Well what’s the mechanism through which that happened? Well it’s kind of convoluted. Basically it’s called – the expansionary fiscal contractionary hypothesis.

Big words. What does it mean? It means the following, and I’m being quite serious when I describe it this way: So the economy is in recession. You’re a bit worried about the future. You don’t know if your spouse is going to have a job next week. But you lie awake at night worrying about government debt and government bond yields. So you’re very happy when the government decides, in the middle of a recession, to cut spending, because that tells you that 20 years from now, you’re going to have less taxes to pay because the welfare state is smaller. Buoyed by that, you go out today and buy a couch at Ikea, thereby curing the recession.

I’m not making that up, that’s really at the heart of the argument, and it’s clearly nonsense. Now, taking those positive cases, why were they positive if that mechanism is nonsense? It’s because they were all small countries that were very open to the international economy, and their major trading partners had big expansions. Think Canada next door to the United States, Denmark next door to the EU. At the same time, those countries had their own currencies, and they devalued their currencies, which gave them a huge export competiveness boost. That’s really what happened. It’s nothing to do with cutting spending; it’s a sideshow. Cutting spending or spending falling is a sideshow because it’s a consequence of growth, not a prerequisite for it.

We keep doing it because it protects the banking system from its own excesses, because if that were to go, every pension in euroland would go bang, and all the banks would go in the north as well. That’s what this crisis has been about from the start; that’s what it continues to be about.

Now, the proof of this is on another level. We’ve run a giant natural experiment over the past seven years. The United States didn’t cut. The sequester was $78 billion, either side of discretionary and nondiscretionary, on a $15 trillion economy. That’s chicken feed. And the minute it stopped doing that, its growth went from 2 percent to 3.5 percent. The Brits, for all their tough talk about austerity, have hacked the hell out of their welfare state, as you would expect a conservative government to do, but they stopped crushing central government consumption in late 2011, and their economy turned around and recovered, albeit with housing bubbles and everything you’d expect of the British economy.

Meanwhile, Europe, which shares a common currency, has been simultaneously contracting. Everybody’s been either cutting aggressively under duress, the Portuguese, the Spanish, and the Greek cases, or has been cutting the margin, the French and the Italian cases. But the result is, when everybody cuts at once, all that happens is the underlying economy gets smaller, your GDP shrinks. And if your GDP shrinks, the same stock of debt gets bigger rather than smaller.

The bit [with The Transatlantic Trade and Investment Partnership] that’s got this secrecy around it and the bit that everyone’s worried about are what is called the “Investor Protection Clauses,” and what it basically means is that companies that invest can sue governments for policies they don’t like.

As the denominator contracts, the numerator gets bigger, and that’s exactly what we’ve seen in the eurozone. So whether you deal on the micrologic of expectations, the logic of country-specific policies, or the macro economy on the global level, by looking at the US, the UK, and the eurozone, the results are in: This stuff doesn’t work, and there’s no logical basis for saying that it does.

So why do we keep doing it? We keep doing it because it protects the banking system from its own excesses, because if that were to go, every pension in euroland would go bang, and all the banks would go in the north as well. That’s what this crisis has been about from the start, that’s what it continues to be about.

Recently, the EU made public for the first time documents pertaining to its ongoing negotiations with the United States over the proposed Transatlantic Trade and Investment Partnership, which is also known as TTIP. What is this proposed partnership, and would it be a good thing economically for Europe and the United States?

It’s a bit of a puzzle for me actually, because these are already the most integrated places in the world in terms of trade. So the US and the EU, they trade together, the rich developed areas, although Europe’s been doing a good job to make itself look less rich, but nonetheless they’re already tightly integrated.

The people who want this treaty say that it will add, I think, about 1.25 percent in GDP, which is at a reasonable clip of growth, half a year’s growth. Not to be sniffed at, but hardly enough to send everybody to their retirement homes at 50 years old. So why all the heat on this?

The bit that’s got this secrecy around it and the bit that everyone’s worried about are what is called the “Investor Protection Clauses,” and what it basically means is that companies that invest can sue governments for policies they don’t like. So imagine, for example, that Denmark deregulates parts of its health-care system and allows in a bunch of American companies, and those American companies start to do things, and after a while the government says “Hey, we don’t like the way you’re doing this.” So they pass a law that says social protection, only this part of the health-care market is open to competition. Then the firm can turn around and sue the government for lost profits. Now this has already happened in many places, and primarily between the developing countries and foreign multinationals. So the big fear is that you have American multinationals suing European governments, and European multinationals suing state governments in the United States, and it’s all very opaque.

Now, who does this benefit? Ultimately it benefits firms, and why do we want to benefit firms? Because many politicians are essentially beholden to them and also because there’s an argument that by securing property rights, you’re going to get more investment, but that’s a bit like the argument “if you cut capital gains tax you get more investment,” and that’s proven to be nonsense. So there’s a great deal of skepticism about this. If it doesn’t go through, it wouldn’t change anything. These will still be the most tightly integrated places on earth. So essentially, I would look to the politics of this and who’s going to benefit, which is essentially firms – which is why people are rightly questioning it.

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