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New Year predictions #2 – Grexit or the Greenback ?


Patrick Kelliher

I have been meaning to write on Greece for some time now. In some ways, Grexit seems old hat compared to the risks posed by Brexit, Trump and China’s debt bubble, but while there may be less column inches devoted to the stand-off between Greece and its creditors, the threat that this could spill over into a disorderly default by Greece remains. Last month, creditors suspended short term debt relief for Greece after the Syrzia government used higher than expected tax revenues to give pensioners a Christmas bonus and defer VAT increases on islands at the forefront of the Syrian refugee crisis [1].

Personally, I think the troika of the IMF, EU and ECB should have given Greece a break. For one thing Greece has had to bear a disproportionate burden from the influx of Syrian refugees. To criticise VAT relief for the main islands affected is churlish. German talk about solidarity and sharing the burden of refugees ring hollow in light of this begrudgery.

More importantly, they should have recognised that the Greek people have trudged along an economic calvary since 2010 with a relentless series of cutbacks and tax rises. While government spending and deficits have not really improved as a percentage of GDP – government spending amounted to 55% of GDP in 2015 with a deficit of 7.5% of GDP, compared 52.5% and 11% respectively in 2010 – this needs to be considered in the context of the collapse in GDP as a result of the austerity: GDP was 22% lower in 2015 compared to 2010. In Euro terms, government spending has fallen by an eye-watering 18% from €119bn to €97bn [2]. There is a link between such swinging cuts in spending, the falls in GDP and falls in tax revenues which are down 10% over 2010/15 despite tax rises. Austerity has clearly failed to address Greece’s fiscal problems and has probably made matters worse.

Greeks cannot wear a hair shirt indefinitely, and there needs to be serious debt relief to reduce debt down to a manageable level. The IMF recognises this. Yet despite the sacrifices and misery of the Greeks, many EU countries particularly Germany are unwilling to countenance serious debt relief for Greece. To do so would be politically unpalatable as it would mean a loss for taxpayers – the key impact of the bailouts has been to change Greece’s creditors from banks and other private sector investors to the IMF and EU governments.

Yet the current situation is untenable. As they continue with austerity with little relief, more and more Greeks will ask “why bother” ? If EU countries do not join the IMF in writing down Greece’s debt, then I think at some stage the Greek people will say enough is enough and renege on their debts.

This would be the nuclear option. By defaulting on its debts to fellow EU governments, Greece would become a pariah state in the EU. It is likely to face EU sanctions including the withdrawal of structural funds. The ECB would pull the plug on Greek banks which rely on its liquidity support. These banks would fail en masse.

Greece’s tax revenues are still below government expenditure, even if interest on debt is excluded. It has to borrow just to open schools, pay pensions and meet other day to day expenses. It is generally agreed that Greece would have to leave the Euro in default: with no support from the ECB or fellow governments, most assume it would have to adopt its own currency to pay the bills. Moreover, it is commonly assumed that leaving the Euro is not possible without leaving the EU as Greece is bound by EU treaties to adopt the Euro.

However, I am not convinced Greece’s future choices are limited to honouring its debts and Grexit. I think there is a third course where Greece defaults on its debts but still manages to stay on in the Eurozone. While defaulting on its debts would cut off access to the ECB and a supply of Euros, the Greek government could meet the shortfall in its tax revenues by paying its bills in “scrip”: government IOUs denominated in Euros. These would not be legal tender – the Euro would continue as the currency of Greece and proper Euro notes would still be the preserve of the ECB – but the Greek government could accept scrip in lieu of taxes owed. With government employees and pensioners paid in this manner, most Greek businesses would have little option but to accept these. To make them more palatable, the scrip notes may be redeemed after say 20+ years with a bonus linked to inflation or nominal GDP growth.

A possible analogy is Scottish banknotes which are not legal tender but which are widely accepted [3] but a more pertinent example might be “Demand notes” issued by the US Federal government in 1861 at the start of the American Civil War [4]. With the Union struggling to finance an ever growing army, Congress authorised up to US$50m to be raised in the form of these notes which were not legal tenders but IOUs. The government convinced soldiers and businesses to accept these in lieu of dollar coins which were legal tender. The reverse side this paper money was printed in green ink, and while over time the notes were replaced by dollar notes which were legal tender, to this day the US dollar is still called the “greenback” because of these demand notes.

So we can talk of the "greenback" precedent for a financially strapped government to issue IOUs instead of legal tender. This could help get around any shortfall in finances which may arise following a Greek default. As well shortfalls in tax revenues relative to day-to-day expenditure, the Greek government is likely to need finance to take over its failed banks. I would expect the government to compensate depositors up to €100,000 in line with EU rules. This compensation could be credited to accounts at a new government bank but withdrawals from these accounts would still have to be met. They could be paid for in scrip. The scrip option thus gives Greece financial flexibility while staying in the Eurozone (nominally at least).

This is not to say default will be an easy option. With banks failing, haircuts would need to be imposed on depositors above the €100,000 level depending on the residual value of assets after compensation payments [5]. Many businesses could be made insolvent or face liquidity crises as a result of haircuts to their cash balances. At the least, the new government bank would probably need to extend overdrafts to prevent widespread insolvencies, but even this may not be enough. I would expect a sharp economic contraction as a result.

This is just one of the many problems with default and scrip option. Overseas suppliers would not accept scrip and would seek payment in hard currency. Greece would need to impose currency controls to preserve Euros to pay for essential imports such as medicines. The Greek government would probably still have to pay some interest on its debts to avoid a total rupture with its fellow EU governments, which will further eat into hard currency. At the same time, Greeks are likely to hoard Euros in line with Greshams law that bad money drives out good, complicating efforts to preserve Euros. Many businesses would not be able to import supplies as a result of currency controls which would lead to further failures and economic contraction. Meanwhile, businesses paid in scrip may jack up their prices, which would lead to inflation on top of the economic downturn.

Therefore, as bad as things are at present, default could be a lot worse for Greece, even if it managed to hang on nominally to the Euro and stay in the EU. However, for a proud people suffering continued austerity, they may prefer the devil they don’t know. As Brexit has shown, sentiment can trump reasoned economic arguments.

A disorderly Greek default would not just have implications for Greece. If the scrip option is proven to be viable, other governments could be tempted to go down this route if debt burdens become too much. At the least this would adversely affect perceptions of Eurozone sovereign default risk.

There would be economic implications as well. The collapse in Greek imports described would have adverse consequences for those exporting to Greece but the impact would be modest as Greece accounts for a small percentage of Eurozone GDP. On the other hand, if a larger country went down this route then the economic impact may be more profound. In particular Italy – which is probably too big to be bailed out anyway – could resort to this if it ever found itself unable to roll over debt. The associated capital controls resulting could damage wider Eurozone demand.

Finally, if Greece defaults on its obligations to fellow EU governments the resulting political fall-out might tear at the fabric of the EU itself. For instance, if Greece defaulted before September’s German elections, the losses this would (theoretically) cause German taxpayer could propel the anti-EU Alternative for Deutschland (AfD) into power, adding to woes caused by Brexit (and the possible election of Marine le Pen in French elections in May).

To conclude, EU governments probably assume that a Greek default will lead to Grexit and that Greece would never pursue this option as a result, but if so they are being unduly complacent. Brexit has shown that people can choose to reject the EU. From above, I also think there are ways for Greece to stay in the EU and default. Ultimately, in not considering serious debt relief for Greece, EU governments could trigger a more severe loss on default which could deal a fatal blow to the EU itself.

[1] See and

[2] Source: Eurostat (

[3]  …in Scotland at least. The analogy is not perfect as Scottish banknotes are backed by equivalent deposits at the Bank of England so they are backed by real currency as opposed to a government promise.


[5] Residual assets would be further reduced by the ECB’s claim on the choicest of bank assets pledged to it as collateral.

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