Why Greek Exit From The Euro Would Be A Very Bad Idea

2/17/2015 @ 7:50PM

Frances Coppola

http://www.forbes.com/sites/francescoppola/2015/02/17/why-greek-exit-from-the-euro-would-be-a-very-bad-idea/

Ever since the election of the Syriza government, there has been growing talk of Greece leaving the Euro. Markets are jittery: fears of Greek default and exit are forcing up Greek bond yields, and the Greek stock market is on a roller-coaster ride, falling with every piece of news that suggests rising exit risk then bouncing back when exit doesn’t happen and everyone calms down. There is a silent run on Greek banks as depositors fearful of re-denomination losses remove their funds to safe havens.

And it’s easy to see where those funds are going. German claims on the Target2 settlement system are rising fast, leading uber-hawk Professor Hans Werner Sinn to demand capital controls be imposed to end capital flight from Greece. Exactly why he thinks capital controls are a good idea at this stage is not entirely clear: he seems to fear that the rest of the Eurozone will be forced to bail out the Greek central bank, which is providing liquidity through the ELA scheme to enable those funds to be moved without bankrupting Greek banks.

The question of the Target2 claims and the solvency of central banks is a perennial can of worms, and I don’t propose to go into it here. Suffice it to say that as long as the Greek central bank can provide funding to Greek banks against collateral there is no risk of insolvency of either the banks or the central bank, and therefore no risk to other Eurozone countries. The real risk is that a Greek sovereign default would render Greek banks’ collateral worthless, making it impossible for them to obtain even emergency funding. This would technically bankrupt the Greek central bank and trigger disorderly collapse of the Greek banking system.

But insolvency of the Greek central bank would frankly be the least of anyone’s worries in the event of a Greek sovereign default. The majority of Greek sovereign debt is held not by banks – even Greek ones – but by a range of EU institutions including the ECB, the EFSF and Eurozone governments through bilateral lending. And by the IMF . All of these institutions would lose substantial amounts of money if Greece defaulted on its debt. This would be the case whether or not Greek default was accompanied by exit from the Euro.

It is in no-one’s interests for Greece to default, and very foolish indeed for the Eurozone to indulge in the sort of brinkmanship that could force it to default. Have we so soon forgotten the failure of the last-minute talks intended to rescue Lehman Brothers? We surely are not going to make the mistake of believing that there would be no systemic consequences from a Greek default. Default of a sovereign is NEVER without systemic consequences, however small the country – and Greece, although a small country, is certainly not insignificant.

When a sovereign defaults, the systemic shock transmits itself to others through the balance of payments channel as trade is abruptly truncated and capital flees. This happens whether or not banks are fire-walled: if they are, then the casualties are companies that do business in the defaulting country, their suppliers, employees and shareholders, and sovereigns that rely on those companies and their employees for tax revenues. It is particularly disastrous for those countries with the strongest trade links to the defaulter. In the case of Greece, that would be Eurozone countries, Russia and Middle Eastern oil and gas exporters. Geopolitical risk, much?

Disorderly failure of a sovereign is every bit as disastrous for those connected to it via trade and capital links as disorderly failure of a bank. Those who think that Greece should be pushed into default and exit as punishment for daring to challenge the terms of its bailout program would do well to remember this.

But should Greece leave the Eurozone anyway? Some think that it would be better for it to leave. It could then set up its own currency, re-denominate its debts into the new currency and reflate its economy. The currency would devalue significantly, giving it competitive advantage, while monetary reflation would stimulate the economy and payment of debt in the (devalued) new currency would be far less onerous. What’s not to like?

There is a great deal not to like. For Greece, the consequences would be pretty unpleasant, at least in the short term.

Firstly, re-denominating debt into a new currency would be regarded as default, which would mean Greece being shut out of markets for some considerable period of time. It does have a small primary surplus, so could meet its domestic fiscal obligations, but debt service in the new currency would require money printing, as would monetary reflation. I am not a great supporter of knee-jerk “money printing=hyperinflation” theories, but the combination of money printing with a fast devaluing currency does raise the risk of high inflation and “dollarization” of the economy.

Secondly, Greece is an importer of certain essential items, notably oil and gas, for which it must pay in hard currency – dollars, or a currency that can readily be swapped into dollars. If its own currency were freely traded, it could exchange it for dollars, but devaluation would quickly make oil and gas imports prohibitively expensive. A foreign exchange crisis would be on the cards rather soon after exit, I suspect.

Of course Greece could peg its new currency to the dollar or the Euro, but maintaining such a peg when the currency is devaluing would quickly burn through its scarce reserves. A currency board arrangement like Bulgaria’s might also be a possibility – but it is hard to see that this is any improvement on Euro membership. Bulgaria has been in outright deflation for the last three years because of very tight monetary policy arising from the need to back all lev issuance with Euros. And this is without considering the negative effect on trade of re-denominating into a devalued currency with no international standing.

Exit would mean a sharp recession in an already depressed economy. It would not be welcomed by the Greek population, which despite everything is still substantially in favor of Euro membership. For all these reasons, the Syriza government is – wisely – unwilling to countenance Greek exit.

But the consequences would also be pretty bad for the Eurozone. Greek exit would amount to sovereign default. And the shock would transmit itself to the rest of the Eurozone via the balance of payments channel as I have described. The Eurozone would also therefore suffer a sharp recession, as would its trade partners. Periphery countries such as Spain would find their green shoots of recovery squashed, their fiscal deficits rising again and their debt/gdp soaring. Further austerity to bring these down would no doubt be imposed, increasing public unrest and improving the electoral prospects of populist parties such as Podemos.

And this raises the specter of exit contagion. Once one country has left the Euro, others can. It’s like adultery: once the line has been crossed once, it is likely to be crossed again….. For the Eurozone to force out Greece would therefore set a very dangerous precedent. As Draghi pointed out in a speech given in Helsinki in November 2014, if a country left the Euro it would no longer be a single currency. It would simply be a managed exchange rate system – and managed exchange rate systems are vulnerable to speculative attack and sudden disorderly failure. The Euro’s predecessor the Exchange Rate Mechanism unraveled very quickly indeed once the UK was forced out. At the moment it seems unimaginable that the Euro could similarly unravel, but that is because the mechanism by which countries could leave has not been established and the precedent has not been set. If that were to change, the situation might be very different.

Allowing the Euro to unravel or the Eurozone to fall further into depression due to a disorderly sovereign default and exit when Ukraine is blowing up, Moldova is about to follow suit and the Russian bear is growling on the borders of the Baltics would be the height of folly. It is also worth remembering that Greece is a Balkan country, and Russia is very interested in the Balkans for strategic reasons to do with gas pipelines, oil refineries and warm-water ports. A Russian delegation arrived on Syriza’s doorstep the day after it was elected: although Syriza has ruled out accepting loans from Russia (and Russia’s current shortage of Euros suggests that loans are not very likely anyway), special trade deals and FDI are a distinct possibility – but probably not while Greece remains a member of the Euro.

There is also the little matter of the other Balkan countries: Bulgaria is talking about joining the Euro (though it admits it is nowhere near ready at the moment), and Serbia is a candidate for EU membership. How would their attitude be affected by Greece being forced to leave the Euro and possibly the EU as well? Then there is Turkey, Greece’s Islamic neighbor, which is perennially interested in EU membership but is increasingly looking east, and Hungary, an EU member that is modelling itself as a Russian-style “illiberal state” and running dangerously close to breaching EU membership rules. The eastern border of the EU is a melting pot. Greek exit could only make it even more unstable.

It is therefore not only unwise for Greece to decide to leave the Euro, but equally unwise for the Eurozone to force it out. For better or for worse, this partnership must stay together. As Draghi said, the Euro must be irrevocable in ALL its countries: for it to succeed anywhere, it must succeed everywhere. The only way any single country can leave the Euro is if ALL countries decide to leave it – in other words, if the Eurozone countries decide that the Euro should be wound up. That, at the moment, is not on the cards.

And therefore neither is Greek exit. This foolish talk of “Grexit” must end. It is a major distraction from the real tasks facing the EU leadership, which are sorting out the dysfunctional institutional structure of the Eurozone, setting economic policies that prioritize growth and prosperity over debt reduction, and above all, ensuring the peace and stability that are the purpose for which the European Union was established in the first place.