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.