Twilight Of The Eurozone?
Talk of a Greek exit, like many eurozone issues before it, has made the transition from sedition to acceptability. At the moment, banks put its chances anywhere from 50% to 90%. In the most sensitive public conversations with European officials, the idea is being considered. And some of the more candid, informal, chats I’ve had in the US with senior economists suggest it’s inevitable. But emboldened by example and encouraged to think through the logic of an exit, the conclusions are deeply unsettling for the members that could be left behind — the ‘residual eurozone’.
Broadly, there are two sets of threats that the residual eurozone will face after a Greek exit. The first is obvious, partially precedented, but yet unpredictable. It is the ‘contagion effect’ that will follow the collapse of an advanced economy that is simultaneously trying to tear itself free from the shackles of economic union. It is obvious because a costless collapse is inconceivable. It is partially precedented because we’ve seen this sort of thing before (the 1997 Asian financial crisis is a good example). And it is unpredictable because there is no single, determinate way in which it would happen. Some variables are in our hands (e.g. whether a new currency is introduced). Some are clearly not (e.g. the damage done to confidence outside Greece).
In the event that the eurozone can tolerate the destructive impact of the first threat, then the remaining 16 members will face a second, subtler, but more dangerous threat. It is the ‘reversibility effect’. If Greece were to leave, then the idea of the eurozone as an irreversible arrangement, the central premise on which the current institutional architecture is predicated, will be revealed as a bluff. The permanence of the setup will be exposed as pretence. What was once inconceivable will become perfectly feasible. And it will beg a grave question – if Greece can leave, then why not others? For the first time, this question will be legitimate. And the answer is worryingly unclear.
This is the problem Martin Wolf set up yesterday. A Greek exit would create a ‘permanent precedent’. The eurozone would go from being an ‘irrevocable union’ to an ‘exceptionally rigid fixed currency system’. In this post, I unpick the problem, and, in closing, make three proposals that I think are necessary to keep the residual eurozone together.
The Greek situation
Greece is in their fifth year of recession. Each year since the crisis began has been progressively worse, with consecutive contractions in output growing year on year (a further 7% in 2011). One in five people of working age in Greece are now unemployed (twice as high as the rest of the eurozone). Almost half of young people are unemployed. It’s conceivable that, within a few years, the downturn will be greater than that experienced by the US during the Great Depression (where output fell by around 29% compared to 16% in Greece today). Their economy is tanking.
On top of this, the prospects for bringing down debt levels are almost non-existent. For each year the Greek economy contracts, it less likely that they can get their debt under control. Simply put, as their economy contracts, revenue falls (e.g. less tax revenue) expenditure is pushed up (e.g. more benefit payments), and GDP falls. The result is precisely the opposite of what is wanted — a rise, not a fall in the debt to GDP ratio. Reducing the ratio from 160% (where it is today) to 120% (the official 2020 target) looks hopelessly optimistic. Nobody surely believes this can be done. According to debt sustainability analysis leaked a few months ago, even the best-case scenario sees debt at 129% (and a worse case as high as 160%).
Of course, the response to these challenges need not be a Greek exit. There is a reason why 80% of Greeks remain in favour of staying in the eurozone. Bluntly, the prospects for the Greeks on exit are dire – sovereign default (there will be no further bailouts), bank run after bank run (there will be no lender of last resort), complete economic collapse, and social chaos (as Martin Wolf wryly points out, it will be up to an unpaid police force and army to maintain order). And, if they do remain, prospects have brightened with Angela Merkel’s announcement that a Greek stimulus is perhaps an option, and Barack Obama’s emphasis at the G8 on growth.
But as the hiss of capital flight from Greece gets louder (now up to €700m a day), the Athenian stock market falls to the lowest level since 1992, Greek banks are downgraded, and political intransigence sends voters back to Greek polling booths, the time has come properly to explore the implications of an exit for the residual eurozone.
The reversibility threat
As I wrote at the outset, a Greek exit would present the residual eurozone with two main threats — the contagion effect and the reversibility effect. The former will hit first and, while that is playing out, the latter will start to unfold. There has been speculation for a while on what the first could look like (I considered it a little in the opening, but see here for some a few more thoughts). But the second threat hasn’t attracted nearly as much attention.
What then is this second threat?
It emerges from the reality that a Greece exit will establish the eurozone as an impermanent arrangement. Or, to put it another way, it makes it clear that the arrangement is reversible. This idea might sound a little trivial given that we have entertained talk of an exit for a while. But there is a material difference between speculative chatter about an event, and it actually taking place. The leap from the hypothetical to the real is a very, very big one. Once an exit actually makes real the reversibility, it will be increasingly difficult to keep the remaining 16 countries together.
Why will it be difficult to keep the residual eurozone together?
In short, because the borrowing rates that individual countries face will face a very strong pressure to diverge further. Recall that when any country issues sovereign debt, the risk premium attached to it (and so in turn the borrowing rate) reflects two things: the likelihood of default by the member issuing debt, and the likelihood of devaluation by that member. The divergence in borrowing rates then arises because the size of this risk premium (and so the associated borrowing rate) will be pushed up for certain distressed eurozone members (think Ireland, Italy, Spain, and perhaps France) if Greece were to leave.
Why will borrowing rates be pushed up on exit for certain distressed members?
Consider the two cases in question — where the eurozone is irreversible, and where it is reversible. In the former irreversible case, the risk premium that distressed countries face is heavy ‘diluted’. On the one hand, it is diluted because the likelihood of default is lower — there is a presumption of a ‘bailout’ by other members. And on the other hand, it is diluted because the likelihood of devaluation is lower — members in effect are issuing debt in a ‘foreign currency’ i.e. the euro. The distressed eurozone member faces a lower cost of issuing debt (because the risk premium is lower) than it would outside the union.
But if Greece leaves, and the eurozone is revealed as reversible then this dilution effect is significantly weakened. The prospect of bailouts for distressed members slumps as the door is now open for an exit as an alternative option. And the chance of devaluation soars because, if the distressed country were to leave and reissue a new currency, that currency will plummet against the euro.
The worry then is clear. Distressed eurozone countries (again, think Italy, Ireland, Spain, perhaps France) will face far higher borrowing costs than they otherwise would. When Lehman Brothers collapsed, bond yields across the eurozone began to diverge (this chart shows it nicely). Without the diluting effect associated with an irreversible union, this divergence will start to accelerate.
If then the eurozone is resilient enough to weather the first threat, what can be done to bolster the eurozone against this second threat?
Twilight Of The Idol?
In the event of a Greek exit, assurances alone that the residual union is irreversible will not be credible. For this is precisely what was said before. Instead, three moves are necessary to maintain the integrity of the eurozone, and prevent further disintegration.
First, a radical fiscal union centred on Eurobonds (bonds jointly issued, and for the repayment of which all members are jointly liable) must be established. Implicitly, this is the principle that governs a truly irreversible union – that members of the union inescapably sink or swim together. Formalizing this principle in a visible commitment to meet the obligations of other members will stand as a serious signal of intent to protect the future of the eurozone.
Secondly, fiscal union must be used as a step towards deeper political union. Without political reform, joint debt issuance and collective liability will be seen as unjustified. If one member’s population is held financially accountable for another member’s fiscal profligacy (for Eurobond debt must be repaid collectively), and the people of the former do not have a say over of the behaviour of the latter, then with good reason this arrangement will be seen as illegitimate. German Finance Minister Wolfgang Schaeuble’s call for political unity this week was the right one, and should be acted on swiftly.
The third move is the most unpleasant. The residual eurozone must avoid making the Greek exit too comfortable for the Greeks. If the exit is too orderly, soft, and swift then the incentive for another distressed eurozone member to follow the Greek precedent will be stronger. And the expectation of further exits will only drive greater distance between the borrowing rates that residual members face. It is a tragedy for the Greeks that the more fractious and painful their exit is, the likelier that the future integrity of the eurozone is upheld.
Each of these proposals has its risks, and their associated costs will not be evenly distributed across current members. But if a Greek exit takes place, and the decision is made to maintain the residual eurozone, they must be accepted.
Dan,
Thanks for a characteristically clear piece, which strikes me, as a non-expert, as extremely sensible stuff.
The one point I might take issue with is your final one, namely, the suggestion that “the residual eurozone must avoid making the Greek exit too comfortable for the Greeks.” This seems unfair, even callous, not least since you acknowledge that prospects for the Greeks upon exit are “dire”. Such a course of action would entail intentionally imposing tangible, material harms on a population which has already suffered great hardship, in the name of a highly uncertain incentive effect on other countries. It would be like the US dropping five nukes on Japan, rather than two, so as to provide extra deterrence to a potential future aggressor.
Am I being unfair?
Alex,
This is a great point, and has stirred a few people over the past few days. Your point is a fair one, but it tackles a proposal I wasn’t intending to make. So it’s helpful to have a chance to explain myself and set out my thoughts.
The central point I was trying to put across is that, in the event of a Greek exit, there is a tension between what must to be done to secure the interests of residual eurozone, and what must be done to secure the interest of Greece.
The two respective sets of interests are clear — the residual eurozone wants the union to stay as a contiguous whole, the Greeks want a swift return to economic prosperity in their newfound independence.
And so the tension arises — the means to secure these different interests conflicts. A comfortable exit for Greece (a strong first step in a swift return to prosperity) would be uncomfortable for the residual eurozone (because of the incentive effect I identified – exit might now be tempting for others). This is the worry I was pointing to in my piece.
The question then follows — what is the appropriate policy response to this tension? I agree, intentionally inflicting additional material harms on Greece is unjustifiable — both morally (it has a flavour of collective punishment to it) and instrumentally (further harms to Greece could be counterproductive in keeping the eurozone together — for example, serious political and civil unrest could spread beyond Greece and undermine the eurozone that way). But this approach isn’t what I was calling for in my post.
For there is, I hope, an alternative path. As I wrote, and as you noted too, the consequences for Greece are already dire on exit. And this creates two alternative options, one extreme and the other less so.
The first, extreme alternative, is for the residual eurozone to do nothing when Greece leaves (no further bailouts, no loan issuance on favourable terms etc). The dire effects of exit would be enough. To reuse your example, it would be akin to the US not sending aid teams to Hiroshima and Nagasaki, rather than dropping extra bombs.
The second, less extreme, alternative is for the residual eurozone to *moderate* their support. And the degree to which they ought to moderate their support would be just enough to make exit for further distressed members undesirable, balanced against any obligations the residual eurozone feel they have to Greece. This is the position that I take.
Now, both these alternatives may be infeasible. It may be that from the point of view of residual eurozone countries a Greek exit (absent any residual eurozone support) is dire, but not as dire as remaining in the union. In this case, even if the residual eurozone does nothing, distressed residual members may still leave.
If this is true then, given I agree with you that actively acting to make the Greek exit *more* painful is unjustifiable, we reach an important conclusion — it may be impossible to tackle the ‘reversibility effect’. In the event of a Greek exit, it will be infeasible (in any justifiable way) to stop the residual eurozone disintegrating.
This is a powerful conclusion. And, if the logic is sound, it should play an important part in the argument of anyone putting together the case against the Greek exit.
Dan
Great article. I suggest that that a Greek exit is being talked about now by Eurozone policitians to introduce moral hazard to Greek decision making. Greek voters can reject a bail-out at the polls, but they have to know there will be consequences in maintaining that position. This carries enormous risks, but the present position where Greeks vote against austerity and want to remain in the Eurozone is clearly untenable. The current talk of a Greek exit is IMO a strategy to get the Greeks to elect the ‘right’ government in the election next month. The EU has form in this regard where referenda have gone against the European Project.
One other point: Were Greece to exit the Eurozone, then the Bank of Greece would immediately start printing drachmas. Therefore public servants would be paid, albeit the value of their salaries would erode with inflation caused by starting up the printing presses.
Thanks — really glad to hear you enjoyed it. And that’s an interesting thought — we’ll see if you’re right on June 17!
Dan
Extremely informative as always Dan. Like Alex, I took issue with your final point, but feel you have cleared it up in your response. Looking forward to your next “UK domiciled” blog post.
Danny — thank you. Glad to hear it.
Very penetrating article Dan, and nicely written, (also liked how you wove some Nietzsche in there; it’s kind of ironic how what he describes as their ‘twilight’ is considered nostalgically by the Greeks as a lost golden age).
It seems to me that the situation is now further complicated by the fact that a) the new Greek government is willing to do anything to remain in the euro, b) the eurozone is facing more pressing problems to the west of Greece and c) there is no official mechanism for exit which makes it rather unclear who will pull the trigger. What do you make of this?
I doubt, however, that the reversibility effect is as poignant as you state: the imminent disaster of an Grexit is abundantly clear to Greeks and others similarly placed. For consumption-driven, import-dependent countries like mine, the cost of a euro exit – in the form of inability to raise cash in foreign markets and huge increases in import prices – will be sufficiently high to deter any bold policy moves by the PI(G)S, equally dependent on their richer, manufacturing neighbors.
What appears to me problematic in the coverage of the crisis in the international press is how monolithically “Greece” is portrayed. Since “Greece” was responsible for gulping up so much cash in the past decades and sieving it through an inefficient public-sector driven economy, it should now pay up. However, it is worth bearing in mind the obvious but often neglected fact that the country is made up of a series of social groups, some of which have been responsible for the creation of the crisis, but most have not. But now everybody suffers. For some the situation is bordering a humanitarian disaster, with pensioners unable to buy life saving medication and families giving up their children for adoption to richer households. So I would be very hesitant to suggest refraining from assuaging the pain of a possible exit: the supposed danger might not exist, whereas the humanitarian cost is certain. A