Panicos Demetriades, University of Leicester
This 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.
- This post is reproduced with kind permission from Professor Panicos Demetriades’ blog Give good economics a chance
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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