Greece’s last card

Panicos Demetriades, University of Leicester

Professor Panicos Demetriades, University of LeicesterThis may sound surprising to many: last week’s events have strengthened Greece’s bargaining position.

In its current state Greece, having reached rock bottom, has little to lose by exiting the eurozone. Let’s do some back of the envelope calculations of costs and benefits for Greece remaining a member of euroland. Greece is being forced to take more fiscal austerity that will sink the country into even deeper recession, without any prospect of reducing the debt significantly. It is being forced into fire sale privatisations, which will do more in terms of undermining its sovereignty than reducing its debt. Add to that the excessively high interest rates that Greece is paying on its debt. These have more to do with the bad policies that are being inflicted on it and the uncertainty of being a member of a currency union that cannot get its act together than economic fundamentals; according to some recent estimates  Greece is paying 400 basis points for the privilege of being a member of the eurozone. That is equivalent to 6.0 per cent of its shrinking GDP.

What are the benefits from remaining a member? An over-valued currency? The inability to control one’s monetary and now fiscal policy? Ooops, these are actually costs.

More trade with the eurozone because of less exchange risk? Surely not, if the country is forced to use an over-valued currency.

Less inflation? That may well be the case, but with a debt of 150% of GDP higher inflation is a sure way to make it more sustainable. Not to mention that in a deep recession, what should have more weight in monetary policy is reducing high unemployment, which is crippling the country and causing social unrest.

Convergence with the eurozone? This has clearly not happened.

Lower transaction costs? No exchange rate uncertainty vis-à-vis other eurozone members. Maybe. But these are probably pretty low – around 1% of GDP if that.

To sum up, in its present state the costs for Greece remaining a member of the eurozone far exceed the benefits.

However, the costs to other countries of Greece exiting are much higher. Greece, by exiting, can turn itself into a source of a massive externality for the rest of the eurozone. If Greece exits, it is likely that Portugal will be forced to exit next. Then it could be Ireland, Cyprus, Italy, Belgium, Spain and Malta. Not necessarily in that order. France and Germany themselves cannot be ruled out. A disorderly unravelling of the eurozone can have massive costs for all its members, especially so for countries like Germany, whose export sectors have benefited most from the union.

Some economists seem to believe it is possible to create a firewall around the other countries, even most of those in the periphery. That argument is flawed. It underestimates the strength of financial contagion and the turmoil that will ensue when Greece exits. When the first domino falls, the rest will fall rather quickly. It is all a matter of (lack of) confidence in the eurozone. Of which a lot exists at the moment.

If Greece abandons the euro, there will be massive losses in countries whose banks have lent to it, including France, Germany, Cyprus and others. This is true however Greece exits. If Greece is able to change the currency in which its debt is denominated (some analysts believe it can), it will be in her interest to do so. As the Drachma depreciates or is devalued, foreign creditors will be hit by massive foreign exchange losses.

If Greece is unable to re-denominate its debt into Drachmas, Greece’s exit from the eurozone will need to be accompanied by a massive haircut of her creditors in order to make the debt sustainable (otherwise the external debt burden will become even less sustainable as the Drachma depreciates). A 50% haircut is clearly on the low side. If a country is to default, why not go all the way? An 80% or even 90% haircut is therefore more likely.

Bank losses themselves will spread quickly and even banks that may have appeared healthy could get into trouble, if they made the mistake to lend to banks that lent to Greece. Bank bailouts will make more sovereign debts look less sustainable, raising interest rates throughout the eurozone. As confidence in the euro evaporates quickly, bank runs will ensue. Suddenly, other currencies like the Swiss Franc and the Dollar will become more appealing, even in countries like Germany.

Such bank runs will no doubt test the ECB’s ability to maintain financial stability. The ECB can easily make matters worse by continuing to hide behind its price stability mandate and not print enough money, as this can be considered inflationary. All we have seen so far does not inspire much confidence in the institution. It is perfectly capable of allowing the eurozone to unravel in order to achieve its 2.0 per cent inflation target (as I have explained in The suicidal tendencies of the eurozone).

The exit of Greece from the eurozone could, therefore, make the collapse of Lehman look like child’s play. At this point in time, Greece has first mover advantage. Greece has a strong card to play before the end of this game.

Panicos Demetriades is Professor of Financial Economics at the University of Leicester. He holds a PhD in Economics from the University of Cambridge and is Treasurer of the Money, Macro and Finance Research Group. His research interests are in the area of finance and development and his work has frequently challenged mainstream views. For example, as early as 1996 he warned against accepting the view that more finance is always good for growth.

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6 Comments

  1. Jackson
    Posted 01/07/2011 at 13:55 | Permalink

    Looks like the Greek Government has made the wrong call. Public spending cuts, although probably necessary, don’t really deal with the debt if they hit tax revenues and certainly don’t deal with the over-inflated currency (in respect to them) they are pegged to.

    See you all back here for Greek Crisis round 3.

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  2. ads
    Posted 29/06/2011 at 07:52 | Permalink

    North Europe has a Plan B for the EURO, don’t spoil it!

    Most counties around the north sea never joined the Euro.
    Why not found the old sucsecfull Hanse tradae block again. Togethe with Netherlands, UK , Norway GER & Scandinavia etc we rere far more stable and successful then the Renaissance guys.

    Yes, we loose 30% on the EURO exit, but we know what we got:
    Real Friends & future of Northern Europe.
    Probably Profit withe a strong new currency.

    Take your loss. Europe was never one.
    No one united EUrope last thousand years and that is it’s strength. Greece is for holidays and you should pay there with holiday fake drachma. Greek people will have a bright future as one big holiday resort with holiday currency. How they manage, the market will judge. Please be what you are and want to be.

    It is reasonable th ask for a moment where to say STOP. At this moment no one tells. That is alone reason enough to leave the Euro. North Europe has a Plan B, don’t spoil it! If you do not have a serious plan, you cannot negotiate. The north has a plan B and it is even better off. This is the end of the EU. Political decisions without a seroius plan B are always bad. Like entering the Euro, afganitan and much more. Never pay without having an alternative. It is blackmail politics.

    North Knows!

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  3. Chris Williams
    Posted 25/06/2011 at 09:26 | Permalink

    Most people now work for organisations that are subsidised or paid for from taxation. Banks, quangos, Councils, Housing Associations, the BBC, the list is endless. Those who are not subsidised work in the economy of skimming. The zero sum gain industries where profits and losses circulate but remain the same. The only real profits in the skimming industries come from the consumer. Gas is traded on average 8 times between the well and the retailer, each trade making a profit that you and I will pay. Orange juice, coffee, wheat, iron, copper et al.

    The real industries, manufacturing, transport, retailing, infrastructure, agriculture still exist but most people service the needs of others. Is this how the world should work? I skim from you, you skim from me and the bankers skim from all of us. Could we change it. Should we change it. How far can the imbalance between makers ands servicers go. Is skimming the true economy. If you are an economist I would like to read your views.

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  4. Rural Retreat
    Posted 24/06/2011 at 17:52 | Permalink

    The bit I don’t understand is this. Greece is paying very high interest rates. Presumably because people are concerned they will default. So when organisations lent Greece the money at these rates they would have priced in that risk. So now Greece is about to default what’s the big deal? The creditors will have to lose some of their money. It’s called capitalism.

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    Chris Williams Reply:

    We have seen the way it works in the far east when US banks over invested in Asian property. They got the IMF to force countries like Indonesia to accept loans from which the bankers were immediately paid back their investment leaving the Indonesian people to pay of the debt. Having succeeded in Asia they were willing to chance their arm with the US Government. With their own man as head of the Treasury, they successfully strong armed Alan Greenspan to “change his mind” when he pointed out that there was no real growth in the economy. Infiltrated by bankers, the US government capitulated to blackmail and the world followed.

    The interest rates Greece has to pay are designed to ensure a second bail out is necessary. In that bail out the bankers get their money back with large profits. The new new loans are secured against the EU not Greece an so are almost risk free. What got the bankers fired up was the possibility that the EU would allow Greece to default. They sent out their tame journalists to talk up the ‘disaster’ that would follow such and event. The bail out is almost certain. Palms will be greased, lucrative jobs will be offered, profits will be trousered. It’s called capitalism.

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  5. Frank Dawson
    Posted 23/06/2011 at 18:07 | Permalink

    “Greece is paying 400 basis points for the privilege of being a member of the eurozone”

    Surely Greece is paying 400 basis points extra because of huge budget deficits and a lack of fiscal responsibility?

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    Jackson Reply:

    But if it wasn’t wedded to the Eurozone its currency would fall, stimulating its exports and delivering the growth that they need to balance the budget.

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  6. Jackson
    Posted 23/06/2011 at 10:49 | Permalink

    Monetary union without fiscal and political union never really made sense. Greece needs good old fashioned devaluation. And then to pay its debts in drachmas.

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