Now that Greece has defaulted, what comes next?

The easy part of gauging likely outcomes in the Greek sovereign debt crisis was predicting default within the eurozone. But now that this has happened, the situation becomes murkier and it is unclear what will happen next. Below I will put together a few thoughts on how to frame the dilemma. But, in the end, my answers are as uncertain as anyone else’s.

About four months ago, I looked at the developing negotiating stances in the Greek situation and I determined there was very little room for mutually acceptable outcomes. Here’s how I put it on 27 Feb:

“My view: The German interpretation of the extension is untenable politically for Syriza. And if it comes to implementing on those lines – as the IMF and the EC voiced concerns too, we won’t even get to the end of April before this agreement collapses. The Greeks need to be preparing their economy and financial system for capital controls and default right now. This is very important because, even if we get past April, there are going to be no writedowns in June. That’s clear from the German side. And that’s not going to fly in Greece politically. A longer-term agreement has a high likelihood of failure. And so default is a good probability then. Greece should be working on parallel currency options as well as ways to prevent deposit flight and bolstering bank capital including the prospect of turning to the Russians as Cyprus seems to have just done. This could be explosive politically.

“And then the question becomes redenomination for Greece and whether that same risk lies elsewhere, with the Spanish elections looming large in this debate later in the year. Europe is not out of the woods by a long shot.”

So we have finally arrived at this point and we are no closer to understanding how high redenomination risk is than we were in late February. Here’s why? I wrote a mental model for understanding policy errors and consistency anchors using the Fed and Greece back in February. The framing I chose to analyze the Greek situation from is built around actors faced with a decision-tree analysis at each step in time. And each time it comes to making a decision, an actor is faced with two choices: one is to weight probabilities and the other is to assess uncertainty. By that I mean that most incumbent leaders, when weighing a course of action, will avoid taking decisions which increase the level of uncertainty because uncertainty increases policy errors that potentially undermine the incumbent’s leadership position.

Here are the important bits on how I put it in February: most people are anchored by a prior decision that they will defend tooth and nail, irrespective of whether doing so is actually advantageous. The reason for this is the need for consistency. That’s because consistency is a defining trait for what we perceive as honest, trustworthy, rational human beings. People who are inconsistent are seen as illogical, deceitful and untrustworthy. And so we strive to be as consistent as we possibly can – even when doing so is actually not in our best interests. Thus, human beings sometimes make decisions that are globally rational in that they maximize ideological consistency across time but that are locally suboptimal, creating Knightian uncertainty that generates market tail risk.

This is exactly what is happening in Greece. And I believe the default outcome was predictable given this framework and the negotiating stances in February. But now that we have arrived at the logical outcome, we have to iterate the process with a new actor, the ECB. My sense here is that the ECB feels constrained as well and that it will be forced to limit assistance to Greece in a way that forces the Greek banking system to collapse. So the capital controls in place will either have to stay in place until Syriza bends to the will of the ECB as governments elsewhere in Europe have done or they will have to nationalize large parts or all of the banking system.

If Greece were to nationalize its banking system, default on most of its Troika interest and principal repayment obligations, reduce government expenditures and institute local scrip or a parallel currency, it could potentially operate in a limbo status indefinitely, giving it time to either convince the electorate to leave the eurozone or to convince the creditors to provide meaningful haircuts to existing loans.

Now, this option, while difficult, is, at this juncture, not materially worse in terms of economic outcomes than one in which the Greek government capitulates, accepts the Troika offer and institutes austerity and reforms. A lack of consistency via capitulation could mean the political end for Tsipras and his government. So I believe the consistency anchor makes the capitulation option less likely, even though the outcome is more certain and probably better economically. However, if Tsipras chooses this option and his party does not splinter, the Greek government has another chance to get to a fiscal surplus, reduce bank reliance on ELA and then try to force writedowns again at some point in the next two years.

So the two real options are:

1. Prepare to be cut off by the ECB, nationalize the banks, introduce scrip or a parallel currency, reduce government expenditures, renege on all Troika commitments and wait out a credit writedown deal or exit the eurozone.
2. Capitulate and accept front-loaded austerity, risk a splintering of the party, but live another day to eventually gain a primary surplus and less dependence on ELA in order to re-negotiate for credit writedowns at a later date.

Neither of these options are very palatable.

From the Troika perspective, I still do not expect an offer for writedowns and this is the key sticking point. For whatever reason – that writedowns or debt forgiveness were not given elsewhere or the political non-viability of offering writedowns – EU politicians see writedowns as a red line. And frankly, no credible deal is possible without writedowns. So that means we should expect the Troika to wait for Greece to capitulate – and if they don’t, decide how to respond. I believe contagion will be limited unless Greece exits the eurozone – and this will embolden EU politicians in pressing their advantage.

I should point out here that there is no way to kick an eurozone member country out. You need for them to apply to leave the eurozone – and perhaps the European Union as a whole, and this departure must be agreed upon by all members of the EU. Now, Article 7 of the EU treaty is an article that has never been invoked but that does give the EU powers to suspend voting power for a member country, denying a member country privileges of membership while member EU obligations continue. Here’s article 7 in full – with bold on the important bits:

1. On a reasoned proposal by one third of the Member States, by the European Parliament or by the European Commission, the Council, acting by a majority of four fifths of its members after obtaining the consent of the European Parliament, may determine that there is a clear risk of a serious breach by a Member State of the values referred to in Article 2. Before making such a determination, the Council shall hear the Member State in question and may address recommendations to it, acting in accordance with the same procedure.

   The Council shall regularly verify that the grounds on which such a determination was made continue to apply.

2. The European Council, acting by unanimity on a proposal by one third of the Member States or by the Commission and after obtaining the consent of the European Parliament, may determine the existence of a serious and persistent breach by a Member State of the values referred to in Article 2, after inviting the Member State in question to submit its observations.

3. Where a determination under paragraph 2 has been made, the Council, acting by a qualified majority, may decide to suspend certain of the rights deriving from the application of the Treaties to the Member State in question, including the voting rights of the representative of the government of that Member State in the Council. In doing so, the Council shall take into account the possible consequences of such a suspension on the rights and obligations of natural and legal persons.

   The obligations of the Member State in question under this Treaty shall in any case continue to be binding on that State.

4. The Council, acting by a qualified majority, may decide subsequently to vary or revoke measures taken under paragraph 3 in response to changes in the situation which led to their being imposed.
5. The voting arrangements applying to the European Parliament, the European Council and the Council for the purposes of this Article are laid down in Article 354 of the Treaty on the Functioning of the European Union.

This is a clause to prevent a country from benefiting from EU membership while doing things the EU members disapprove of. They were thinking of human rights abuses and the like. But it could be invoked for using a parallel currency as legal tender, for example. Think of it as a nuclear option to force Greece to heel or to exit the eurozone.