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The Drachma Drama

Deepak Shenoy
Atlas Invested

Two years ago, there was a crisis in Greece, when it couldn't pay back debt that it had taken. The government's debt was 120% of GDP then. The country simply couldn't afford to pay back its loans, and the impact would have been felt all over Europe, where banks and funds had lent to Greek institutions and to the Greek government. Greece wasn't the only one in trouble — Portugal, Ireland, Italy and Spain were also in the now-infamous acronym for countries in trouble, PIIGS.

The initial reaction to the problems in Greece was to give them more money to help them pay back what they owed. A 120 billion Euro package first materialized on the promise, by the Greeks, that they'd try to earn more money from taxes and spend less. The problem? More than 50% of the Greek economy was from government spending, and reducing that meant that lots of Greek people would earn lesser and thus pay lesser taxes. The "black" or unaccounted economy in Greece remains very large, with people preferring to not declare income so they won't have to pay taxes.

Given these dynamics, the new "austerity" measures had two major consequences: They ticked off the Greek people, who wondered why they couldn't default on the debt instead. More importantly, the measures didn't help reduce the deficit at all. Austerity meant lower spending, even where it was required, and then, lower investment. A falling deficit as a percentage of an GDP that falls faster does no good. With GDP continuing to fall, and social unrest almost constant over the years, Greek unemployment soared, rising to as much as 54% in Feb 2012.

In the interim, understanding that regardless of a rescue package, Greek would be unable to pay, the European powers decided to ask the lenders to Greece - essentially, owners of Greek bonds — to see if they could take a "haircut". They would only be paid a fraction of the value of the bonds they owned, on the condition that they use the money to buy longer term Greek debt. The haircut would involve losses to the lenders, but at least they would get something instead of the near-nothing they would if Greece actually defaulted and refused to pay anything.

Lenders agreed, under stress. Yet, the crisis didn't go away. The conditions for the haircut were that Greece take on even more austerity measures, which to the Greek people was like hitting a man when he's down. The insistence by Germany that money should not be printed by the European Central Bank (ECB) to save Greece stemmed from their fear of hyperinflation which they saw in the 1920s. But only money printing would rescue the troubled Euro governments — print more Euros, use it to buy government debt, and hope that the governments will fix themselves by imposing austerity rules that don't allow them to do much. In fact Germany even attempted to send tax collectors to ensure proper tax reporting in Greece, only to find that the Greeks that weren't willing to pay tax to Greeks were definitely not inclined to oblige a German.

The loss of sovereignty, the lack of jobs and the tense political situation has resulted in a majority of Greeks supporting parties that were more radical in thought. The left-wing Syriza won over 17% of the vote while pro-austerity parties saw their vote-share reduce from 85% to 34%. With Syriza not willing to make a deal with any party that supported austerity, no majority could be found and Greece will go to elections again. With the economy still in shambles (Greek GDP fell 6% in the first quarter of 2012) voters are very likely to vote socialist again, and give the anti-austerity parties a majority. What happens then?

With no austerity, Greece will not get the European payments that it needs in order to pay back the debt it owes. It will then have to default on that debt, or some of it. The popular impression is that this will result in it's expulsion from the Eurozone, which means the Greek Central Bank will be back in action printing the drachma as a national currency. Greeks who own Euros in Greek banks will be forced to take back the new drachmas in a pre-fixed conversion ratio (I believe it could be 1:1).

As the drachma comes into play the Greek central bank will need to keep printing the drachma to pay for government spending, which will be a result of "no-more-austerity". The excess printing will, in time, cause inflation and the exchange rate to drop dramatically. And if they default on international debt, chances are that Greece will be shunned by the international community for a while, which means supply shortages of food, oil and other commodities (that Greece imports).

The greater concern for those on the outside is that lenders to Greece will suddenly become insolvent, with their meagre capital wiped out due to the extremely high leverage of nearly 20:1 they seem to have. To recapitalize the banks, the individual governments will need more cash, and when Greek debt goes to zero, the other Eurozone countries start seeing a shakedown as well. Even now, Spanish and Italian debt yields have gone up (that means they have to pay higher rates) and Portugal's yields are soaring.

Austerity at one end, inflation and shortages at the other. Greece has to make its choice but it seems that the people have decided. Austerity, in the current form, can't work. Even if they have to deal with the eventual turmoil, they might stand a better chance by going out of the Euro and defaulting, even partially, on the debt they owe. Other countries balk at having to hurt because Greece does, but short of a war they have little choice. Democracy is, at the extreme, Demo-crazy, the rule of madmen.

Yet the fault cannot lie with Greece alone. It had to leave the Euro anyhow; austerity of that extreme could never have worked, just like crippling a man doesn't make him earn any more than he did. But in a world where everyone is crippled, chances increase.

Deepak Shenoy writes at Capital Mind, and is co-founder at MarketVision, a financial knowledge company. You can reach him at or @deepakshenoy.