Greek Drama and the Eurozone’s Future: Wharton’s Franklin Allen Weighs In

For many parts of Europe, summer solstice on June 21 is time to celebrate with street parties and picnics into the late hours. But this summer solstice, Greek Prime Minister George Papandreou had a different reason to celebrate. After a week of political drama within his Socialist Pasok party and a new wave of violent riots in the streets, he survived a vote of confidence on the longest day of the year, helping to pave the way for his plans to unleash further austerity measures to keep the country afloat.

It has been just over a year since he shepherded in a multibillion-euro rescue package from the International Monetary Fund and the European Union, which commits Greece to several more years of drastic budget cuts and — as politicians hope — will save it from defaulting on its staggering debt. “If we give up in the middle of the road, history will judge us harshly,” declared Papandreou shortly before the vote.

Not as harshly as it would if Greece decides not to stay the course and chooses to leave the eurozone, according to Wharton finance professor Franklin Allen. In this interview with Knowledge@Wharton, he outlines his thoughts on why Greece could be on a different road than the one Papandreou, and many of other European leaders, have in mind.

In April, Allen co-chaired a conference in Florence, Italy, held by Wharton and the European University Institute, which brought together a number of banking and finance experts to explore whether Greece should default and if it did, what the repercussions for it — and the other members of the eurozone — would be. A new e-book co-edited by Allen titled, Life in the Eurozone With or Without Sovereign Default?, captures the various alternatives discussed and debated at the conference and can be downloaded here.

An edited transcript of Knowledge@Wharton’s conversation with Allen about the eurozone’s leaders — and lenders — follows.

Knowledge@Wharton: Considering the problems that Greece and other European economies are going through, some economists wonder whether the eurozone might break up and if the euro, as a currency, will survive. What do you think?

Franklin Allen: There is a risk of break-up. If we look at the eurozone countries, by and large there are two camps. There are the Germans with the other Northern Europeans, which would include the Netherlands, Finland, Austria, Estonia and those kinds of countries which are fiscally austere and don’t have problems in terms of deficits. On the other hand, we have the Southern European countries, such as Greece, Portugal — I think we can put Ireland in that category for the moment — Spain and Italy. France is somewhere in between. My guess is that France, if push comes to shove, will probably go with the Southern eurozone.

What is happening is that the official sector wants to deny that there is a serious long-run problem. So, on the current trajectory, they are forcing Greece to go to about 170% or 180% of [its] GDP in debt. This, in my view, is simply not a viable path. For the Greeks to dig themselves out on that path, they’re going to have to put maybe 7% to 10% of GDP in just paying interest. This is not possible, given their track record in terms of deficits.

One of two things, in my view, is likely to happen. Either this situation will persist for a couple of years and then the public sector — which will be the European Economic Union, in terms of the European Financial Stability Facility, or if it goes on past 2013, the European Stability Mechanism — will own most of the debt. The private sector will effectively have been bought out. That’s what’s happening at the moment. And then, they’re going to have to face a problem. People call it a bailout, but so far it’s just loans. But it will need to become a bailout, in the sense that there will need to be a significant transfer, probably of several hundred billion euros from the surplus countries to Greece. This is a big problem because the Maastricht Treaty explicitly rules it out, the German constitution explicitly rules it out and the political process in many Northern European countries is trying to rule it out. We see that most extremely in Finland and Germany. So I think that would be a very difficult way to go.

The other route is that at some point the Greeks will simply say, “We’ve had enough of this and we’re leaving.” Overnight, they will go ahead and convert their debts to the extent they’re local. [The local tranche is] about 80% to 90% of the sovereign debt, and presumably most of the private debt and the bank debt and so on. They’ll convert from one euro to one new drachma. And then the next day, [the new currency] will float. Initially, probably, it will go down to about two drachma, two-and-a-half drachma to a euro. And what we’ll see then is Greece will become more competitive quite quickly and hopefully start growing. It will not have access to capital markets for some time but experience seems to show that [the lack of access is] surprisingly short. And the fact that they’ll be able to, essentially, lower their debt burden by a half or by two-thirds, on not only the sovereign debt, but also much of the private debt, I think will be a boost.

These two outcomes are equally likely, roughly speaking. What we’re seeing at the moment is a struggle. It’s a political struggle between various factions in the EU to see which of these outcomes will come about.

The European Central Bank (ECB) seems to want the first outcome but I think they underestimate the political resistance in Northern Europe to these problems. They are likely to suffer greatly if Greece pulls out, because there will be a big contagion effect. The Irish and Portuguese will think seriously about pulling out, too.

Knowledge@Wharton: You mean they will go back to their own currencies?

Allen: They may go into their own currencies temporarily. The impact on the ECB, which has recapitalized recently, if all these things happen, is a possible bankruptcy. This is not a problem in any real economic sense. But politically, it’s going to look terrible that the ECB goes bankrupt.

It’s very unfortunate that the current leadership at the ECB is taking the route it is because in four months, we’re going to have a transfer of power from [the current French president, Jean-Claude] Trichet to [Italy's Mario] Draghi. Many Northern Europeans are extremely skeptical at a level where they don’t really know who Draghi is. If you know who Draghi is, he’s a very confidence-building person. But for the person in the street in Germany or the Netherlands, having an Italian in control of the central bank is a worrying thing. And if they see, a few months after he arrives, that the ECB goes bankrupt, this will not be a good event for the bank and will multiply its political problems.

My own view is that it would be better off to take the hit now. Let Greece default. They should have done that a year ago. They didn’t want to. But they should let that happen now. Get the decks cleared before Draghi comes on board. Then they can see Greece grow and potentially get out of this problem.

What we’re seeing at the moment is that [the solutions being imposed on Greece] are not working. The people are on the streets in large numbers, and we’ve still got two years of austerity measures to go — so it’s going to be extremely difficult. The IMF plan was that they would be able to access markets by next year. That’s not going to happen. They should have been growing but fairly soon. That’s not going to happen. We’re seeing a 10% drop in GDP and unemployment, particularly youth unemployment, is going up. The plan is simply not working. The sooner we recognize that and come up with an alternative, the better. The options at this stage are either the Northern countries primarily, but the EU essentially, comes up with the money to give to Greece to write off this debt. Or there’s a default. Or the Greeks leave the eurozone. I think these are more likely to happen than the official scenario.

Knowledge@Wharton: Speaking of the IMF, we still have the question of who becomes the head. Are you concerned about how that will shape the outcome?

Allen: The Europeans have captured the IMF to a much greater degree than should have happened. We saw that after Strauss-Kahn stepped down, they became a lot tougher in terms of enforcing the rule book. One of the issues has been that there was a conflict of interest. Strauss-Kahn was basically running for president of France [in the 2012 elections] and the IMF didn’t do what it normally would have done. And that’s a problem. Now the Europeans are arguing, “We have to have a European head because so much of what the IMF has done is in Europe.” We’ve seen many people effectively make that argument. It’s interesting that no one suggested in 1997 that we should have an Asian as the head, because of the Asian crisis, or in 1982 that we should have a Latin American because of the problems in Latin America.

It’s almost certain that [France's finance minister] Christine Legarde will become the next head of the IMF. My main hope at this stage is that President Obama realizes that this is a terrible system we have in place, whereby the Europeans get the head of IMF and the Americans get the number two and the president of the World Bank. That system needs to be ended now. It should have been ended with a non-European becoming the head of the IMF. I don’t think that’s going to happen. But let’s at least have the number two be a non-European. [Mexican central bank governor Agustin] Carstens may not get to be the head of the IMF, but he should at least get the number two position, in my view. This would at least be a compromise of some sort that would salvage what otherwise will be a terrible event.

If such a compromise doesn’t happen, my concern is that the IMF will become more and more irrelevant. China has much more money than the IMF. The non-Europeans — especially the Latin Americans, Africans, Asians — will be much more willing to go to the Chinese directly or to a Chinese-backed entity to get loans than they will the IMF, and essentially the IMF will simply become the European Monetary Fund. Already, the last figures I saw show that about 80% of what they do is in Eastern, Central and Western Europe now.

That is, in my view, not a good outcome. What we’re seeing effectively is many poor countries in Africa and Latin America giving money [to institutions like the IMF], which is going to some of the richest countries in the world. We think of Greece and Portugal as being poor, but relative to African countries, of course, or India or many parts of Southeast Asia, they’re incredibly wealthy. Ireland, of course, is actually one of the wealthiest countries in the world. It’s not far below the U.S. and well ahead of Germany, the U.K. and France. For us to be taking money from poor countries to give to rich countries is something that the colonialists in 19th century could have dreamed about [laughs] as being better than what they did. But it’s terrible. It’s terrible.

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