It could come sooner; it might well drag out longer; it can still be averted: but the week following the next Greek election on June 17th still looks set to be the time when the euro zone’s debilitating fever peaks, and the patient’s prognosis becomes clear. That election could well produce a government determined to renege on or radically renegotiate the reforms and austerity measures its predecessor committed the country to at the time of the second bail-out, earlier this year. If that happens, the rest of Europe will have to decide whether to be party to those negotiations or to walk away.
If European leaders follow through on their threats to enforce those terms, the flow of bail-out money to the Greek government will stop. Since March Greece has received half of the €145 billion ($185 billion) it is due to get from the European Financial Stability Facility (EFSF), the euro area’s temporary rescue fund, by the end of 2014. And it has received a first payment of €1.6 billion out of a total €28 billion due from the IMF by early 2016.
Although the Greek government is close to running a primary budget surplus (i.e., before interest payments) it still needs further official loans to honour obligations due this year, notably redemptions of bonds held by the European Central Bank (ECB), which were excluded from the restructuring in March that slashed the face value of €200 billion of debt held by private bondholders by over half. If the lifeline from the EFSF were cut off by its creditor nations, Greece would be unable to pay those debts. And if the ECB makes it a matter of principle not to lend (or permit the Bank of Greece to lend) to banks against collateral consisting of bonds and guarantees from a government in default, then it in turn would cut Greece off. Greek banks currently rely upon some €130 billion of central-bank funding. Without the ECB money the entire banking system would collapse. If the flow of money was reduced, and the conditions it is lent on tightened, the Greek government might start to issue IOUs to its workers to make up the shortfall. If the flow stopped, leaving the banks no euros to pay out, a new currency would be the only alternative.
The government would redenominate domestic bank assets and liabilities into drachma and insist that domestic contracts, such as pay and prices, be also set in drachma. Capital controls would be necessary because the drachma would immediately fall against the euro, possibly losing 50% or more of its value in a trice.
In the short term Greece’s economic agony—its economy shrank by 13% from 2007 to 2011 and is expected to contract by almost 5% this year—would intensify. A precipitous exit without preparation would leave the country without notes and coin. The surrounding chaos would paralyse economic activity, causing consumers and businesses to stop spending. Economists at UBS, a Swiss bank, have estimated that the cost of a catastrophic exit might amount to 40-50% of GDP in the first year.
That figure assumes that Greece would have to leave the EU as well as the euro, and thus lose access to the single market. On strict legal grounds that may be the case, in part because exit requires capital controls, and those controls are illegal under EU treaties. In practice European policymakers are making it clear they would do their utmost to keep Greece in the EU. Assuming such helpfulness, Mark Cliffe, an economist at ING, a Dutch bank, reckons that the effect would be less. He puts the first-year extra loss of output at 7.5%.
Run Like the Wind
If Greece’s new currency avoided lurching into hyperinflation—which in a chaotic country with a weak government and a new currency would be a serious risk—the country might regain some of its losses the following year. Rather than having to spend years grinding down domestic costs, the exchange-rate fall would provide them overnight, boosting competitiveness. If the country looked safe, stable and welcoming, other Europeans would flock to take their holidays in the Aegean.
If Greece’s new currency avoided lurching into hyperinflation—which in a chaotic country with a weak government and a new currency would be a serious risk—the country might regain some of its losses the following year. Rather than having to spend years grinding down domestic costs, the exchange-rate fall would provide them overnight, boosting competitiveness. If the country looked safe, stable and welcoming, other Europeans would flock to take their holidays in the Aegean.
That is another rather large if; and other Europeans may have a lot more to worry about than holiday planning. European governments would bear losses on the loans they have made to Greece in the various bail-outs. The ECB for its part is exposed in two main ways. Firstly, to calm market tensions after the May 2010 rescue it bought Greek bonds worth about €40 billion. Second, the Bank of Greece owes the ECB around €130 billion in “Target 2” debt, internal obligations within the European central banking system, which would turn into real debt in the event of an exit. All in all, the Greek government owes the governments and institutions of the euro area over €290 billion, about 3% of euro-wide GDP, say economists at Barclays Capital. After an exit most of this would probably never be repaid.
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