The feeling probably is mutual.

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Greece's Next Step: Overdue Debt and IOUs

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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Greece’s dramatic decision to close its banks and impose capital controls has averted -- at huge cost to the economy -- a bank run and limited the flight of euros out of the country. A perilous week still remains ahead.

QuickTake Greece's Fiscal Odyssey

Importantly, none of these desperate efforts will generate new cash for a government that is facing difficulties paying its bills. That means officials will have no choice but to seriously ponder the use of IOUs to meet domestic obligations. Doing so, however, would move Greece one step closer to the introduction of a new currency to replace the euro.

Related: Greece Default Watch

After negotiations with creditors collapsed Friday, lines formed at cash machines over the weekend and on Sunday the European Central Bank refused to provide Emergency Liquidity Assistance. The government then chose to declare a bank holiday rather than deal with the immediate consequences of a nationwide bank run. The announcement was supplemented by restrictions on capital inflows to keep as many euros as possible within the country.

These policy choices are far from costless. The “sudden stop" resulting from the bank closures will aggravate an already alarming and protracted economic downturn, compounding poverty and exceptionally high unemployment. It also does nothing to alleviate Greece’s other pressing problem: The government is running very low on funds; and the deep recession will worsen the cash crunch by devastating tax receipts.

The Greek government has already taken exceptional steps to get its hands on money kept by local authorities and other public sector entities. It will continue to look for any accessible funds. But the sums available will be very small.

It is almost a certainty that Greece will be unable to come up with the 1.5 billion euros it must pay the IMF on Tuesday. It will also find it increasingly difficult to meet domestic obligations, including pension payments, civil servant salaries and suppliers’ bills. The longer the government lacks access to large new sources of funding, the more pressure it will face to consider the introduction of IOUs denominated in euros.

IOUs can work without too much collateral damage, provided they serve as a bridge to a credible source of future funding. This is far from certain to be the case for Greece, especially given its acrimonious and bitter relationship with creditors.  

As a result, if IOUs were introduced in the next few days, they would immediately trade at a discount to euros in a secondary market. The longer such issuance continued, the greater the likelihood the IOUs would be a precursor to the introduction of a new currency.

In addition, such a step could be viewed as the lesser of two evils by those within the Greek government who believe the economy cannot survive a long-term closure of the banking system. A new currency would facilitate the recapitalization of the domestic banking system, though that would entail losses for shareholders and creditors as well as the likelihood of nationalization.

Economists will recognize these conditions as characteristic of the type of adverse “multiple equilibrium” dynamics that have tended to play out in crises in the emerging world. This phenomenon, however, is unfamiliar to many European policy makers, and they would soon discover that the slippery slope can only be avoided with a combination of large incremental financing and comprehensive policy reforms.

For now, with the crisis likely to worsen, the government and its European partners are still quite a distance from being ready to trip those two circuit breakers.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net