Now that the Greek referendum has produced a decisive No vote, never mind what happened before. The real crisis starts now.
It has to be recognised that the Greek people faced a difficult choice. The referendum itself was a political gambit by the Syriza government to seek to split the eurozone governments and obtain a better deal. The politics of defiance has won. It was a major gamble, so will it pay off?
There will be some EU leaders, particularly in France and Italy, who will urge a return to the negotiating table. But the odds which the Greek government now faces are stiff. One political commentator wryly told me in recent days that Syriza has achieved what few others managed: to unite the eurozone governments against it, even those most critical of austerity policies. In my view there is now an 80% probability of Grexit.
The Greek reality
The IMF’s debt sustainability report, which was published on June 26 just days before the vote, shows how dire Greece’s fiscal predicament is. Just a year before, the fund projected the country’s debt/GDP ratio falling from 175% in 2013 to around 128% in 2020. But the poor growth performance and poorer primary fiscal balances have worsened the outlook such that the ratio is now expected to be over 150% by 2020.
Worse is still to come: the report does not yet reflect the negative impact of the current banking closure and capital controls, which will have severely affected economic activity, and numerous commentators have said that the IMF’s growth forecasts for the country are too optimistic.
Although one can partly blame Syriza’s intransigence for the latest economic setbacks, the result of the referendum should be a wake-up call to the eurozone economies that fiscal austerity alone cannot be a solution. Greece’s GDP decline of more than 27% between 2008 and the first quarter of 2015 is one of the worse peacetime economic declines in history.
Following the No vote, the rhetoric on both sides will be turned up another notch, having already sharpened in recent weeks. Northern-European critics point out that none of the reforms to pensions or to the economy, such as privatisations, which were agreed in 2011 have been carried out.
There were supposed to be €23bn (£16bn) of proceeds from privatisation over the 2014–22 period, and further ones which the Greek government promised but which have since been taken off the table. The IMF now notes that there have been privatisations of €3bn in the past five years and forecasts proceeds of only €500m a year over the next few.
In contrast, critics of the troika’s approach argue that Greece’s economy has lagged behind because of a basic lack of domestic demand, and that aiming to run a 3%-4% primary surplus in the national finances is incompatible with any sort of economic recovery.
This polarised debate disguises that the better path probably lies in the middle: Greece does need to improve the supply side of its economy by investing in new technologies and making its existing sectors more competitive. But in the meantime, demand needs to be sustained and you need more than three to four years to radically restructure an economy. In simple terms Greece needs another bailout (probably about €50bn), this time with a major debt restructuring (about €80bn, maybe more) to ensure that a new medium-term economic plan can be adopted which has a chance of working.
That’s what the bargaining should be about, and following the referendum the Tspiras government has a strong mandate. But this will require flexibility so far unseen among the eurozone governments – many have already said publicly that a No would lead to a Greek exit from the euro. Negotiating a new bailout will also take time.
The liquidity threat
But in the short run the main binding constraint is the banking shutdown. It is rumoured that one Greek bank is almost running out of cash, and that the whole banking sector has no more than €500m-€1bn left to dispense: about three days’ worth of cash. Without political cover from the eurozone governments, the European Central Bank (ECB) cannot reverse its move on June 28 to cap the Emergency Liquidity Assistance programme, which led to the closure of Greece’s banks the following day.
Having already received €89bn in assistance to keep functioning, the banks can’t resume business unless the cap is removed. Without additional ECB support, there would quickly be serious dislocation in the economy as businesses and government cannot pay salaries, and key imports like food and medicines cannot be guaranteed. Many businesses would cease to operate. So if the eurozone does not restart negotiations then Grexit could follow, de facto if not de jure, as the banks run out of cash.
If the eurozone shuts out Greece from ECB assistance, the Greek government would then be forced to issue promissory notes or IOUs: in essence the precursor of a new Greek currency, to which the Greek Central Bank and the Greek banks would need to be parties. Indeed, outgoing finance minister Yanis Varoufakis has already indicated that this is a possibility. In theory this exit from the euro could be reversed if an agreement were reached with the eurozone.
But a dual currency limbo cannot last long. Very quickly it would make sense to convert all bank accounts, prices and contracts to the new currency. Because it would take time to issue new drachma notes, euro notes would continue to circulate alongside IOUs. But people would seek to hide them in the knowledge that the new drachma would quickly devalue, probably by about 50%. It is also likely that the euro would eventually stop being legal tender and tight capital controls would operate, with a forcible conversion of euro notes to new drachma notes.
For the creditors, Grexit means Greece could walk away from its debt, which is mostly held by governments rather than European banks. This will have a negative fiscal impact on large eurozone countries like Germany, France, Italy and Spain. But European banks have built up capital reserves in the last five years and should be able to withstand the shock of the sovereign bonds of large eurozone countries that they hold on their balance sheets plunging in value as a result.
For the eurozone, the key will be to prevent a contagion through increasing debt costs to other weaker members such as Spain, Portugal, Ireland and Italy. The ECB will need to use whatever it takes to defend these countries, including its Outright Monetary Transactions programme, under which it can buy their sovereign bonds.
For Greece, debt relief would follow an exit from the eurozone. But there are risks, not least that it would have violated its adherence to EU treaties by exiting the euro. So an exit from the EU, though seemingly implausible, cannot be excluded.
And in spite of having a currency with a much lower value following a Grexit, there might be little benefit to net exports for Greece. This is because the Greek economy is quite closed, with net exports less responsive than might be expected to a devaluation. Greece would also need to maintain a fiscal surplus with no short-run external finance sources. So for Syriza this risks being a pyrrhic victory. For the eurozone and the EU, meanwhile, this is their biggest ever challenge.