We are approaching the end game in the conflict between Greece and its creditors. How likely is it that Greece will leave the euro? It is much more likely now than ever before. Brinkmanship is a national sport in the EU, but we are now at the limits of what is negotiable.
The banking system has basically been suspended until the referendum on July 5 following the introduction of capital controls on Monday June 29, caused by the European Central Bank’s freeze on emergency liquidity assistance at current levels. Everyone knows that Greece is insolvent if there is a No vote. I cannot see the eurozone countries renegotiating the bailout deal in the event of that happening, so a No vote would probably be the beginning of the end.
If there is a Yes vote to endorse the bailout deal, it’s clear from the most recent statements that there will be a political crisis in Greece: the ruling government will not wish to impose further austerity, which it regards as unacceptable, and which some economists see as having worsened the plight of the Greek economy. (Greece’s GDP has shrunk by 25% between 2008 and 2015.) This could then lead to political stalemate in Greece which might mean the crisis is merely postponed.
Where No leads
If Grexit happens, it will not be costless. A return to a (massively devalued) drachma will not engender competitiveness overnight. The level of competitiveness measured by Greece’s GDP deflator relative to the EU has already dropped by 8%-9% since 2014: a real devaluation. But it would need more than this, and it would take a long time to feed through to net exports given Greece’s loss of competitiveness in the decade before.
Economic recovery will also be difficult in the face of an insolvent banking sector, with a credit crunch that will take time to unwind as the new currency is introduced. Although Greece will be able to renegotiate its debt following a Grexit, its bargaining position in this area depends crucially on its ability to deliver a budget surplus, as it will be effectively shut out of any new borrowing. The question is: how robust is that forecast budget surplus following a credit crunch?
There would be substantial costs for the eurozone too. The risk of contagion would require eurozone ministers and the ECB to deploy all the powers at their disposal to prevent the bond yields in southern Europe from rising relative to German bond yields and prompting a further unravelling of the eurozone. There would be substantial losses for eurozone governments which financed the Greek bailouts, but also for the national central banks due to the creation of additional monetary base by the ECB. The losses will be proportionate to the size of each country in the ECB system, ranging from just under 26% for Germany and just under 13% for Spain.
The irony is that, of course, Grexit would compel the creditor countries to renegotiate the unsustainable part of the Greek debt, and reach a more sustainable debt position in an attempt to recover some of that debt. One has to ask why that wasn’t the starting point of the negotiation between the parties during the current crisis, which instead has focused on short-term targets for Greece’s budget surplus.
The reason is that, undoubtedly, restructuring the debt would have had implications for wider eurozone politics. But that ignores the fact that the crisis has been caused by the fundamental design flaws of the eurozone in the first place.
The bigger question is whether a Grexit would fundamentally change the way in which the eurozone pools its sovereignty on fiscal matters, or whether Grexit would be merely the prelude to a further break-up. I think it is unlikely that anything will change in the eurozone’s architecture, meaning that it will create further problems, particularly if any larger economy experiences similar difficulties to Greece in future.