by Calculated Risk on 5/09/2012 08:06:00 PM

The next election in Greece will be on June 17th. The outcome is unpredictable and could determine if Greece will leave the euro. The anti-incumbent vote is very strong, and the new government might reject the entire bailout agreement. However a very large percentage (about 35%) of registered voters didn't participate in the recent election - much higher than normal - and it is possible the turnout will be much higher in June, but no one can predict what a higher turnout would mean.

Here is an excellent review from Marcus Walker at the WSJ: How a Radical Greek Rescue Plan Fell Short

Two years after Europe bailed Greece out to protect the euro, the rescue has become a debacle that threatens to unravel the common currency.

After Greece's May 6 elections left pro-bailout parties too weakened to govern the country, more elections are likely in June, with no guarantee a stable government will emerge. By next month, Athens must identify €11.5 billion, or $15 billion, in fresh spending cuts or face suspension of the international loans it needs to pay pensions and run schools. If it doesn't get the money, it would eventually have to print its own.

Greece's growing turmoil is the culmination of a radical austerity experiment and botched economic overhaul that have pushed the nation to the brink of social and political breakdown. The story of the ill-fated bailout suggests that forcing deep austerity on individual member states won't save the euro and may worsen its crisis.

What Walker doesn't point out is that many economists correctly predicted this approach would fail.

Another excerpt:

Greece's bailout by the EU and International Monetary Fund is the costliest financial rescue of a nation in history, with paid or pledged loans totaling €245 billion. It has already involved the biggest-ever sovereign-debt default, a debt restructuring that wiped out more than €100 billion of Greek bond debt.

Yet the restructuring left Greece with two mountains to climb: curbing a still-rising debt more than 1.5 times the size of its economy, while forcing down wages and prices to make the country competitive.
...
Greece's economy has already shrunk by 14% in the past three years, and IMF officials privately expect a further 6.5% contraction this year. Something has to give, and it could be the boundaries of the euro.

Forcing down wages and prices on a piecemeal basis is very difficult. Nominal wages tend to be sticky downwards, and the adjustment can take years - and the voters will eventually rebel. Another alternative, one that is not currently available to Greece, is to devalue the currency. Matthew Yglesias discussed these two approaches last year:

[L]et's talk about Spain. For a while, a lot of capital was flowing into Spain from abroad. A very large share of that capital went to finance house-building rather than productivity-enhancing factories or infrastructure. But it employed a lot of people in the construction sector and related fields, which pushed tax and spending levels up and also led to rising wages. Then the housing boom ends, the capital flows end, and suddenly Spain has to adjust to a new equilibrium in which most people are a bit poorer than they were before. The most natural way to do this would be through a bit of currency depreciation. Everyone's real wages and pension payouts and local debts to one another are reduced. It's a bummer. But everyone goes on doing the best they can to make a living, and people who are underpaid in the new equilibrium set about to bargain for raises. Depreciation makes vacations in Spain cheap, it makes Spanish exports cheap, and it makes it attractive for rich foreigners to actually go buy up excess Spanish housing stock to use as vacation homes and such. Everyone's taken a hit, but they're back on the path to growth.

The other alternative -- the road we're actually traveling down -- is one in which all of these adjustments need to happen piecemeal. To make the same adjustment happen, every single contract in the country needs to be piecemeal renegotiated. That's every town budget, every cell phone plan, every commercial lease, every salary, etc. It's not "impossible" but it's a logistical and political nightmare. And it takes time. During that time instead of everyone working harder because they're poorer and more indebted than they realized and need to raise their incomes what happens is that 10-20 percent of the population does nothing because they can't find jobs. It's a nightmare and no economy is flexible enough to make it work. You wouldn't just need to repeal the basics of human psychology, you'd need to live in a world where there are no transaction costs and no fixed contracts. Imagine if your boss cut your salary 3 percent and then you set about to try to negotiate a 3 percent discount from your landlord, the electric company, your car insurance, your cable provider, your cell phone carrier, your health insurance plan, and everyone else you owe money to. By contrast, if the trade-weighted value of the dollar were to fall three percent then you have a nice, simple, logistically feasible adjustment that improves the cost structure of U.S.-based exporters and export-competing firms.

Milton Friedman had a similar discussion back in the 1950s, "The case for flexible exchange rates”:

The argument for flexible exchange rates is, strange to say, very nearly identical with the argument for daylight saving time. Isn't it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits?

All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have individual separately change his pattern of reaction to the clock, even though all to do so.

The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, than to rely upon changes in the multitude of prices that together constitute the internal price structure.

Obviously - as we've been discussing - austerity (that includes the piecemeal approach to wage and price adjustments) - will eventually fail at the ballot box.

There is another method of allowing nominal wages and prices to remain steady, and for real wages and prices to fall - with inflation. It might be possible for the ECB to target the inflation rate in the peripheral countries, and ignore inflation in German. Right now the ECB targets inflation in the eurozone, and that means close to deflation in the peripheral countries. But that is a broad brush (they can't just raise inflation in Greece), and this is also currently unacceptable to the Germans.

So, with no way to ease the suffering (no exchange rate mechanism, no higher inflation), that only leaves more years of suffering or exiting the euro. The Greeks may decide on June 17th.