Time for plan B in Greece

Since assuming power this January, the distinguishing feature of Greece’s newly elected Syriza government has been its lack of a coherent economic plan. Instead, it has based policy on the desire to fulfill unrealistic electoral campaign promises and on the wishful hope that its European partners would continue to provide the necessary financing. This has led to a marked loss of both domestic and international confidence that has revived fears of a renewed Greek economic recession. It has also resulted in a marked deterioration in Greece’s public finances that has seriously impaired its ability to honor its international and domestic commitments.

{mosads}Having missed out on a plan A, one has to hope that the Syriza government will quickly formulate a plan B that might limit any further damage to the Greek economy. In particular, one must hope that it will weigh very carefully the relative merits of the three basic options that now confront it. One must also hope that it will immediately disabuse itself from any notion that Greece’s European partners will soon blink in the negotiations and provide Greece additional financing without requiring basic policy reform. Greece’s European partners now seem more determined than ever to avoid moral hazard in the rest of Europe’s periphery and they now believe that Europe is in a better position to weather a Greek exit than it was in 2012.

The Syriza government’s first option would be to continue on its present path of responding to events as they occur without trying to mold them. This will almost certainly lead to a deepening in the Greek crisis as its creditors withhold further funding. That in turn would both force Greece to default on its International Monetary Fund (IMF) and European Central Bank (ECB) debt commitments as well as require Greece to impose damaging capital controls on its banks. In time, it would also force Greece to issue a parallel currency that in the end would lead to a disorderly Greek exit from the euro.

The clear disadvantage of this approach is that it would immediately plunge the Greek economy further into recession and it would seriously undermine the country’s public finances. Under such a scenario, the country would remain indefinitely shut out of the global capital market, while its economy would remain characterized by very high unemployment and the build-up of large payment arrears.

The second option would be for the Syriza government to make a fundamental policy U-turn and come to a quick agreement with its official creditors. Such a U-turn would require the implementation of difficult structural reforms in the areas of pensions, tax administration and the labor market, which could very well split the Syriza Party and force early elections. It would also require the adoption of budget austerity measures in the midst of an economic recession to produce a small primary budget surplus.

Reducing the chances of such an approach being adopted is the fact that it was precisely the policy mix against which Syriza ran in the elections and it is also a policy course that is likely to entail a prolongation of the Greek economic recession. In its favor, however, is the prospect of resumed IMF and ECB lending that could obviate the prospect of default and the imposition of damaging capital controls. It would also spare the country from an immediate and very painful economic crisis.

The third policy option worth considering is that of an orderly exit from the euro as opposed to sleepwalking toward the exit. Such an option is particularly worth consideration if it is to be judged that Greece has already reached the point where defaulting on its official debt and imposing capital controls is now inevitable. If Greece cannot avoid such a fate, at least it might aim at reaping the benefits from freeing itself from the shackles of a euro straitjacket that has made it so difficult to restore competitiveness and to effect budget adjustment without plunging the country ever deeper into recession.

If the Greek government were to opt for the orderly exit approach, it would need to back such an exit up with a sound macroeconomic policy framework aimed at restoring confidence and at preventing the country from drifting toward ever higher inflation. At a minimum, such a framework would require a credible government commitment to maintaining a small primary budget surplus, a central bank commitment to an inflation target and a generalized commitment to supply-side economic reform aimed at modernizing the Greek economy.

This is all not to say that Greece faces easy policy options. However, it is to say that the worst that the Greek government can do is to hew to its present path of stumbling toward default and toward an ignominious exit from the euro. If Greece is to exit from the euro, it would best be done in an orderly and well-managed fashion, which would require that the government adopt a coherent plan of action that it has so far signally failed to do.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.