Almost two years into dealing with the sovereign debt crisis in the Euro area, the problems in Greece are far from being solved. In fact, the free fall of the Greek economy has made the troika’s plans obsolete. Once again the assumptions about GDP development have proven to be overly optimistic. The economy will probably shrink more than the assumed 3%, current estimates actually see the recession as being twice as strong in 2012 than assumed. Given rising internal tensions, growing protests against further reforms, a disorderly default of the Greek state can no longer be excluded. Greece is encountering increasing pressure to fulfill the conditionality attached to the loans provided by the EU and the IMF. The scenario that the troika of IMF, European Commission and European Central Bank actually does not pay out the next tranche of credit in order to keep up pressure on the government to reform and to consolidate is no longer unrealistic.
A possible exit from the euro area is now increasingly debated as a viable policy option both in Athens, but even more so in other Euro area and EU countries (note the debate in Germany and also recently in the Czech republic) where decision-makers are increasingly fed-up with bad news from Greece. As the unwillingness to agree to further rescue packages is growing, more and more people argue that exiting the Euro area would be the only way to give Greece a chance to regain competitiveness (through a strong devaluation of its new currency), while a default would help the country get rid of its overwhelming debt burden.
This post looks at the situation from a Euro area perspective: How do the costs and risks of a Greek default within the Euro area compare to a Greek default with a simultaneous exit from the single currency for the Euro area? The answer given may be somewhat surprising: the Euro area should actually do what it can to keep a defaulting Greece within the currency union rather than letting it exit the Euro area (for the full argument see the policy brief (in German) co-authored with Sebastian Dullien here).
Those who argue the Euro area would be better off without Greece usually assume that the repercussions of a default and an EMU exit can easily be ring-fenced. Isn’t, after all, the European rescue fund EFSF large enough to recapitalize banks if they have to write down further their loans to Greece? In particular as the bulk of Greek debt held by European banks has already been written down and sold to the European Central Bank?
In case of a Greek default, a banking crisis would be imminent. Greek banks would have to write down the Greek bond holdings – which would make some of them insolvent overnight.
Credit provision to the Greek economy would collapse. The government then has to decide whether Greece should actually default in the Euro area. If it does so, it could gain EFSF support to recapitalize its own banks. Legally, this should be possible, though politically it would be more than tricky: all national Parliaments of the countries financing the EFSF would have to agree to give money to a state which has just stopped servicing its loans.
If the Greek government decides to leaves the Euro area, the Greek central bank can start printing money to recapitalize banks and can stop a national banking crisis possibly more effectively. A sharp devaluation of a new drachma and inflation would come with this strategy. But, as Argentina’s case in 2002 has shown, there are ways to limit inflation and to stabilize the economy.
The effects for the EU are largely underestimated. This is firstly true for the de-stabilizing effects on the banking sector in other member states. If Greece leaves the Euro area, all bank deposits, credits and contracts would be converted to the new drachma. This would be done in order to prevent companies and banks from going bankrupt as in case of a strong currency devaluation they would not be able to service their debt issued in euro (the value of which would increase as much as the new Greek currency would devalue).
Consequences for the rest of Europe could be dramatic. As soon as it becomes clear that a euro deposit in a Greek bank would only be worth a new drachma, and hence after devaluation, possibly only 25% of its Euro value, citizens in other EU member states would ask themselves whether the same could happen to them. A bank run in these countries becomes likely, in other words a capital flight from other member states under pressure in the sovereign debt crisis to the core of the euro zone, i.e. to Germany. If private investors panic, several thousand billion Euros can be withdrawn from bank accounts in countries such as Italy, Spain, Portugal and even France. The ability to support the banks suffering from a withdrawal of deposits is limited. The EFSF will not suffice while the ECB could only help indirectly, because for instance Spanish and Italian banks do not have the necessary securities in order to refinance themselves in a normal process. Of course, the national Central Banks could (and would) help through so-called Emergency Liquidity Assistance, but the limits of these instruments yet still need to be defined. In an extreme scenario, this contagion effect could actually confront the governments of Italy and Spain with the choice the leave the Euro or to accept a collapse of their banking sector and hence their fragile economies.
The second aspect that is discussed far too little is the overall political perspective of a possible Greek Euro area exit. Proponents tend to argue that Greece should leave the European currency, but not the EU. This is not compatible with EU law so a political solution would have to be found under extreme circumstances, probably between Athens, Berlin, Paris and Brussels and without full involvement of the other member states. Once out of the Euro area but still in the EU, Greece is unlikely to be an easy partner. One the one hand, it will, of course, still be dependent on EU aid which might raise its willingness to cooperate. But on the other hand, it is likely to be totally destabilized domestically, in political and social terms (if the situation has escalated to such a degree that the country actually chooses to leave the monetary union). In EU decision making, Greece would continue to be a “normal” partner which has to be dealt with politically, which enjoys veto rights in areas of unanimous decision making etc. Cooperation with the 26 other member states will be particularly difficult if the above mentioned contagion effects set in. In the best case then, this will cause bilateral tensions with Greece, in the worst case, it not only drives the Euro area but also the EU apart, both economically and politically.
Such dark scenarios are the reason why a probable Greek default should be treated as one thing, and a Euro area exit of Greece as another. There is no reason why a default of a country should entail an automatic exit from the monetary union. In fact, for the rest of the Euro zone, a Greek default within the currency union may actually be the economically cheaper scenario, while an exit could cause uncontrollable domino effects.
But in order to make it acceptable both to the Greeks and to the citizens of other EU member states to keep Greece in the Euro area, much larger effort needs to be put into the development of a feasible growth strategy for the country which includes a pursuit of the structural reform agenda and the fundamental modernization of the dysfunctional Greek state.