Greece Comes to a Sudden Stop. Now What?

JUN 29, 2015 2:00 AM EDT

By Mohamed A. El-Erian

Sadly, the “Graccident” has happened.

 Bloomberg

The Greek economy is now in intensive care, as its parts -- and notably its banking system -- grind to a halt. The economy that eventually comes out of intensive care will be smaller and uncomfortably different in form, but it will also have the potential to prosper over the longer term if some important decisions are made rapidly and consistently.

The dramatic breakdown in bitterness and acrimony of negotiations this weekend between Greece and its creditors understandably panicked Greeks, who are justifiably worried about their financial well-being. Lines started forming at automatic tellers, as depositors rushed to pull out whatever cash they could. Several machines ran out of money, and it became clear that a full run on the banking system would occur when banks opened on Monday.

Fearing a nationwide bank run, the government decided on Sunday to close the banking system for several days and to impose capital controls. That led the Athens Stock Exchange to announce that it would close, too. The measures were harbingers of what is about to befall Greece: a cascading sequence of closures, shortages, defaults and dislocations.

After enduring a steep contraction of its gross domestic product in the last five years, Greece will now suffer an even deeper depression. Many domestic economic activities will slow markedly, if not grind to a halt. International trade flows will shrink. Debt arrears will mount rapidly. The government will be forced to issue IOUs, de facto establishing a parallel currency. Many businesses, from hospitals to airlines, will have difficulty securing supplies and paying their creditors. Outward migration will spike, as Greeks look to the rest of Europe for jobs. And even the tourist industry will be affected meaningfully.

It is hard to overemphasize the human cost of this “sudden stop.” Poverty will soar; as will the unemployment rate, already at an alarming 26 percent. Stretched safety nets will prove only somewhat adequate, adding to the huge strain on the country’s social fabric. And, through it all, the political discourse will become very ugly, as will the European blame game.

These highly likely developments will make Greece’s continued membership of the euro zone extremely difficult, if not impossible. As a result, the Greek economy that eventually emerges will not just be smaller and fragile, it will also likely operate in a fundamentally different context.

With both Greece and its creditors having failed to avoid a Graccident, they now face the challenge of making the best of a very bad situation. Little can be done at this stage to avoid the cascading failures that come with a sudden stop of the payments system. But a lot can, and should, be done to limit the damage and place the economy on a more sustainable pro-growth path.

The government would need to move quickly to completely restructure the banking system -- much of it likely to be transferred to public ownership. Amid significant losses imposed on an array of constituencies, including shareholders and creditors, the recapitalization of a handful of banks would probably be feasible only in the context of a new monetary arrangement that most likely would involve the return of a national currency.

Concurrently, the government would need to revamp its budgetary process, prioritizing expenditures to favor social sectors and moving aggressively to widen the tax net and combat evasion. This would also be the time to break down oligopolistic and other practices that have held back Greece’s economic potential.

Even though Greece is likely to exit the euro zone, it will be crucial -- for both social and geopolitical reasons -- to ensure that it isn't untethered from Europe. Its European partners -- no matter how frustrated they are now -- have an important responsibility. If they are unable to maintain Greece as a full member of the European Union, they need to quickly come up with some type of association agreement.

No one wished for a Graccident. Yet it has occurred, and its costs are considerable. Urgent steps are now required to ensure some good can result from this horrid situation.

To contact the author on this story:

Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:

Max Berley at mberley@bloomberg.net