Grexit and the Morning After

 MAY 25, 2015 9:24 AM

The New York Times

By Paul Krugman

We just had another electoral earthquake in the euro area: Podemos-backed candidates have won local elections in Madrid and Barcelona. And I hope that the IFKAT — the institutions formerly known as the troika — are paying attention.

The essence of the Greek situation is that the actual parameters of a short-run deal are clear and unavoidable: Greece can’t run a primary budget deficit, because nobody will lend it new money, and it won’t (and basically can’t) run a large primary surplus, because you can’t squeeze even more blood from that stone. So you would think that an agreement for Greece to run a modest primary surplus over the next few years would be easy to reach — that is what will happen, so why not make it official?

But now the IMF is playing bad cop, declaring that it cannot release funds until Syriza toes the line on pensions and labor market reform. The latter is dubious economics — the IMF’s own research doesn’t support enthusiasm about structural reforms, especially in the labor market. The former probably recognizes a real problem — Greece probably can’t deliver what it has promised pensioners — but why should this be an issue over and above the general question of the primary surplus.

What I would urge everyone to do is ask what happens if Greece is in fact pushed out of the euro. (Yes, Grexit — ugly word, but we’re stuck with it.)

It would surely be ugly in Greece, at least at first. Right now the core euro countries believe that the rest of the euro area can handle it, which might be true. Bear in mind, however, that the supposed firewall of ECB support has never actually been tested. If markets lose faith and the time for ECB purchases of Spanish or Italian bonds arises, will it really happen?

But the bigger question is what happens a year or two after Grexit, where the real risk to the euro is not that Greece will fail but that it will succeed. Suppose that a greatly devalued new drachma brings a flood of British beer-drinkers to the Ionian Sea, and Greece starts to recover. This would greatly encourage challengers to austerity and internal devaluation elsewhere.

Think about it. Just the other day the Very Serious Europeans were hailing Spain as a great success story, a vindication of the whole program. Evidently the Spanish people don’t agree. And if the anti-establishment forces have a recovering Greece to point to, the discrediting of the establishment will accelerate.

One conclusion, I guess, is that Germany should try to sabotage Greece post-exit. But I hope that will be considered unacceptable.

So think about it, IFKATs: are you really sure you want to start going down this road?