Planning for Greek default

In my Economic Strategy of 1 June, “Are the Greeks Game?” I noted that the new Finance Minister for Greece, Yanis Varoufakis, is an academic economist specialising in game theory. In game theory, when two parties cannot reach agreement in a bargaining process, this is called “default”. For example, such a bargaining process might involve an employer and an industrial union. Such a default might mean a strike.

We noted that the good news is that every strike results in an industrial agreement. Varoufakis believes that a dispute with Greek’s lenders will eventually result in an agreement which he feels he can calculate.

The game so far

We previously noted that in the previous negotiation in 2012 Greece agreed to eventually run a fiscal surplus of 5% of GDP to stabilise and repay its debt to its creditors. We noted that Yanis Varoufakis had instead suggested an agreement of budget surplus of 1.5% of GDP might be more realistic. Most international commentators agree.

The most reliable commentary on negotiations so far comes from the remarks of IMF Chief Economist, Olivier Blanchard. These remarks were published by Blanchard in his blog of 14 June.

Blanchard notes that the offer made last week to the Greek government proposed to lower the medium term primary budget surplus target from 4.5% of GDP to 3.5% of GDP. He went on “we believe that the even the lower new target cannot be credibly achieved without a comprehensive reform of the value added tax (VAT) involving a widening of its base and a further adjustment of pensions.”

“Why insist on pensions? Pensions and wages account for about 75% of primary spending and the other 25% have already been cut to the bone. Pension expenditures account for over 16% of GDP and transfers from the budget to the pension system are close to 10% of GDP. We believe a reduction of pension expenditures of 1% of GDP (out of 16%) is needed.”

What this means is that the creditors are still insisting on a budget surplus that most international commentators think is unsustainable. The creditors are also continuing to insist on a cut in pensions of 1/16 or 6.25%. This is in a situation where The Guardian UK reports that nearly 45% of Greece’s 2.5 million retirees now live on incomes of less than 665 euros per month which means they are below the poverty line as defined by the European Union.

Most international commentators would suggest that the current offer provided by the creditors is not a sustainable long term solution for Greece. At the time of writing, the Greek government is rejecting this offer.

A scenario for default

This is not a game. This is for real. A default in game theory occurs if the two parties cannot agree. A default in this case means that Greece will not make its payments to the IMF by the end of June. We can only guess at the chance of this happening. Let us assume it is a 50% chance. The size of this chance is therefore alarmingly high.

A plausible scenario suggests that when Greece fails to make its payment to the IMF, then the European Central Bank withdraws its support for the Greek banks. The Greek government might then proclaim an extended bank holiday. In the 1930’s, banks were “temporarily closed” for extended periods while negotiations and reconstruction took place.

These events would immediately throw stockmarkets into turmoil. Markets would sell off towards fair value. We have noted earlier that fair value for the S&P500 is currently 1815 points. This rises to 1884 points by the end of 2015. These fair values are around 300 points lower than the current level. This suggests that such events in Greece, if they occurred, would generate a significant bull market correction. We currently make Australian fair value for the ASX200 at 5,612 points. Presumably we would sell off into undervalued territory.

A scenario for default solution

While the Greek banks are closed, negotiations would continue with the Euro Group. The Euro Group would then be in a situation of not being repaid at all. It may then decide to accept partial repayment from Greece rather than full repayment from Greece. This would then allow Greece to run a sustainable long term surplus and stay in the Euro Area.

If agreement is not reached for a debt reduction, then Greece would default on all of its debt to the Euro Group. The Greek Central Bank would then create a new currency and provide reserves in that new currency to the Greek banks. When the government was satisfied that the banks had been adequately recapitalised, then the banks would re-open and begin business again.

Conclusion

The European Union is a confederacy masquerading as a federation. The major symbol of this pretend federation is a single currency. History tells us that a confederacy is prone to political dissention and civil war.

Agreement to solve the crisis in Greece needs to be found quickly. Should it not be found, the results will be far more than economic.

The shock to the stockmarket will be shortlived. The shock to the structure and the credibility of the European Union will live for many years.