If you think the eurozone will be safe from Grexit contagion, think again

Grexit puts everyone at risk. Martin Capek

For Greece’s government, the July 5 referendum that has just rejected the EU’s bailout package was one step in a long negotiation process. Its ultimate objective is to get Greece’s creditors to agree a bailout package that provides partial relief from debt repayments, together with a substantial debt write-down.

For the creditors, on the other hand, it was a straightforward in/out referendum which will determine Greece’s continued membership in the eurozone and even perhaps the EU. If Greece voted Yes, these creditors were effectively demanding a change of government.

Now those creditors have to be content with the resignation of finance minister Yanis Varoufakis. The rest of the government remains.

Given the pivotal nature of the referendum, the brinkmanship on display was both striking and seemingly foolhardy – possibly borne of a disagreement about what will happen if an agreement can’t be reached. It further complicated what is already a high-stakes and seemingly endless negotiation, which now has to contend with a Greek No victory as well.

Making sense of Greece

After it won the last Greek general election in January, Syriza of course publicly committed to reject any bailout package involving further austerity – though it has since shown willing to compromise this ideal.

Softer stance: Yanis Varoufakis steps down on July 6. EPA

The Greek argument is that austerity is self-defeating, and without a substantial debt restructuring, the prospect of further harm to the country in both the short-run and the medium term outweighs any potential gains from continued eurozone membership. The IMF’s intervention on July 2 seemingly supports this view, proposing relief from debt repayments and a substantial debt write-down in return for a credible plan for economic reforms. Yet while Greek prime minister Alexis Tsipras welcomed this intervention, not all the economic reforms the IMF has in mind might be palatable to Syriza.

The contrary view, of course, is that the current Syriza government in Greece is a recalcitrant debtor with no intention of either paying back its debts or implementing a reform package that stimulates private-sector economic activity. The Greek government has steered clear of conflating a No vote and a strategic default, though, clearly wording the referendum to avoid this interpretation. It seeks a decision from the Greek people on the latest bailout proposal and not euro membership. And the proposal it tabled to the European Stability Mechanism and Eurogroup on June 29 for a new third bailout was an attempt to distance itself from the vitiated wrangling that has characterised the failed talks so far.

Eurozone brinkmanship

Less has been written about the brinkmanship on the part of the eurozone creditors. It signals a belief that the impact of Greece leaving the euro could be contained to its borders and not spread to other eurozone countries labouring under enormous debts. This betrays a false sense of control over the unintended consequences and deep long-term uncertainty that a Grexit would cause.

A different view is that a Grexit would push the eurozone project to the brink. The eurozone constitutes an irrevocable commitment to a monetary union, essentially a fixed-exchange-rate arrangement backed by a central bank and some form of banking union. As we learned from the collapse of the Bretton-Woods system in the 1970s, fixed-exchange-rate regimes between structurally dissimilar economies eventually break down. A common central bank and a banking union might mitigate some of the risks, but without some arrangement to pool the fiscal policies of the different countries involved, it is prone to collapse once the irrevocable commitment to sustain the monetary union is in doubt. Allowing Greece to leave would put the eurozone in that category.

The market would consequently demand a risk premium in relation to the assets of other struggling countries in the zone. It would want to see a pan-European framework of laws in place to mitigate the risks of another country leaving, which doesn’t exist at present. The EU banking resolution framework is still nascent and untested, and Grexit could expose flaws at a particularly turbulent time when its inevitable bank insolvencies would have to be handled in an orderly fashion.

Equally uncertain are the rules governing what happens to commercial contracts between Greek parties and those from elsewhere in the EU, and whether they would be redenominated from euros into new drachma (potentially causing catastrophic losses for non-Greeks if and when that drachma plummeted). This would make the outcomes from any litigation particularly uncertain, which would create further market uncertainty and instability. Indeed regardless of the outcome on Sunday, there is no evidence that the uncertainty will be diminished in this respect.

Further adding to the uncertainty is the fact that the creditors have not yet said whether the bailout negotiations would continue in the event of a Grexit; and the partisan role of the European Central Bank in denying the Greek banks the emergency liquidity to which they are entitled as members of the euro.

There was an unequivocal monetary-policy case for continuing the funding until after the referendum (it stopped on Sunday June 28), as well as renegotiating the austerity programme on which the bailouts depend. The European Central Bank provided no monetary rationale for its decision – yet the European Court of Justice has ruled that the bank’s mandate requires it to ensure the channels for monetary policy remain unblocked. The bank’s evident sensitivity to political headwinds is a problem for the future stability of the eurozone.

The ways in which these scenarios do or don’t play out after the referendum are moot to some extent. Despite the No vote in Greece, a solution will be found in the short term. But to make a difference in the longer term, there will have to be further and deeper economic convergence funded by a 21st-century version of the Marshall Plan for the eurozone’s “south”, together with a new phase of political integration. Since Europe’s citizens want to bring the continent closer together, there is no other option.

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