A default by Greece appears imminent. The country cannot collect taxes, cannot implement reforms fast enough, cannot sell assets fast enough, cannot balance its trade account fast enough, and most of all cannot grow the economy. The rescue package (I refuse to use the word 'bail-out') was always a bet on internal devaluation.
The idea was that, as the Greek economy contracted, real wages would fall relative to the rest of Europe, making Greek exports more competitive. This would stimulate the Greek labor market. Soon, industrial output would be up, unemployment would be down, and Greece would be giving to the world more than it was taking from the world; in other words it would be economically self sufficient. If there was a model for internal devaluation it would be the Baltic model. Latvia, Lithuania and Estonia went through this in 2008-2011, with huge cuts in living standards and a dramatic reversal of the trade account. Unfortunately the socio-political conditions in the Baltics were very different from Greece.
Now that this internal devaluation has failed, the only option which remains is external devaluation. There is also the question of default and how it plays out, which is what most news stories seem to be more interested in at the moment.
Default is a very interesting question. The leaders of Europe appear to be a panic about this; they are rightly concerned about contagion. On the other hand, they do not seem to be able to see past the very short term. For example, the ECB and French President Nicholas Sarkozy pushed hard for German PM Angela Merkel to agree to a renewed austerity and IMF program that would see Greece avoid default. But this plan lacks acknowledgement of the failure of previous similar plans, which are now quite obvious. It also does not take into account political risk in Greece and implementation risk in Greece, which was part of the reason earlier plans also failed.
I cannot believe that such an august assembly of leaders, including all the finance ministers of Europe, the leaders of France and Germany, the governors of the European Central Bank, and the managers of the IMF, fail to see what is being broadcast on the news and spoken openly among non government officials every day. That the current 'stay the course' route is becoming untenable.
What is needed is radical action to stimulate the Greek economy. No more austerity; no more cuts; no more contraction of credit and production. Get people to work. This is a 180 degree reversal of the policy of the past year.
While some sort of default is widely seen as inevitable, most of the sorts of default would cause the Greek economy to continue to contract even further. The more moderate forms of 'voluntary haircut' or organized restructuring are hogwash. In fact no amount of principal reduction of debt would substantially help the Greeks. All it would do is reduce the interest payments on the principal. That would certainly help Greece a little, but their deficits are far larger than those interest payments. Further, this kind of default if it meant that Greece could no longer borrow would result in a sudden, catastrophic contraction of the economy. The Greek government might as well pass a balanced budget tomorrow.
Instead what Greece needs is a currency default. This is the only kind of default that can address the basic structural problems of the Greek economy.
The more common way of doing a currency default is exit of the euro. This would be catastrophic. For one, it would result in a principal default, and all the problems described above. Secondly, it would create problems of contagion. Thirdly, all of the banks in Greece would become insolvent overnight. The only upshot is that the Greeks would once again be in control of their own currency.
Apart from exiting the euro, Greece would remain within the euro and do a currency default. How does this happen? Well instead of Greece defaulting, the ECB 'defaults', by printing more euros to cover the needs of the peripheral economies. It then uses those euros to buy the bonds of the peripheral countries. This would increase the number of euros in circulation, and cause a slight drop in the value of the euro (hence default) but it would not create any systemic problems. And it would allow Greece to move its economic adjustment with more breathing space, holding off on more austerity. It would also help Greece adjust its current account by making Greek exports more competitive. The upshot of this is that it not only works with Greece, it also works with Ireland, Portugal, Spain and Italy. It is also cheaper on the German pocket-book and the IMF pocket-book. In fact, the value of the euro probably would not even fall, because any drop in the euro's value due to the increased quantity of euros in circulation would be counteracted by upward pressure on the euro due to the easing of the peripheral bond crisis. A final advantage of this is that it can be done with only one institution-- the ECB, and is not subject to the requirement that 16 different national political bodies reach consensus. All that is needed is a psychological break from failed financial orthodoxies to solve the euro crisis.