Friday, January 16, 2015

Greece will remain in the euro for now

Greece will hold a snap election on January 25th, after the country’s parliament failed to elect a new president with the necessary majority. Syriza, a left-wing party (or rather a coalition of parties) led by Alexis Tsipras, currently leads the polls. Given Syriza’s outspoken criticism of Greek economic and social policies over the last four years, and its sometimes confrontational statements vis-à-vis the eurozone, some fear that Greece might quit the single currency. This prompts several questions: is it in Greece’s interest to leave? What would be the consequences for the Greek economy and that of the eurozone? And is the rest of the eurozone willing to let Greece go? What follows is an attempt to answer these questions, and to predict what will happen, given what we currently know about the economics and politics of Greece and the eurozone.

Are there any benefits of Grexit for Greece?
Greece would regain autonomy over its monetary policy – the most effective tool for maintaining demand in an economy. Central banks influence the expectations of consumers and investors. Currently, firms in Greece expect low demand and deflation, and consumers low income growth. An independent Greek central bank, if it were able to control inflation, could raise those expectations, leading consumers and investors to spend and invest. The Bank of Greece would also be in a position to ensure that real interest rates (that is, interest rates after accounting for inflation) were low enough to stimulate investment and consumption.

What is more, the likely sharp fall in the value of the drachma against the euro would reverse the loss of trade competitiveness suffered by Greece since it adopted the single currency. Exports would no doubt be slow to recover given the collapse in investment in the country’s tradable sector in recent years. And many structural problems that hold investment back are yet to be tackled. But exports would eventually rise as investment recovered. One sector that would be sure to benefit would be the tourism industry.

After the inevitable default on its euro-denominated debt, the country’s debt burden would be much reduced, allowing the country to run a more expansionary fiscal policy. The Greek government would be able to borrow in its own currency as opposed to the euro, which would enable the Bank of Greece to act as a true lender of last resort to the government. This in turn would allow the government to stand behind the country’s banks. Finally, Greece would in all likelihood end up under an IMF programme, which would require the Greek authorities to persist with much-needed structural reforms in return for financial support.

The short-term would no doubt be chaotic and living standards would inevitably fall further as the price of imported goods rose. However, if the exit was well-managed, the economy could then recover relatively rapidly until the country is running at full potential (it is currently around 15 per cent of GDP below potential). Beyond that, the rate of growth would depend on the success of the Greek authorities in reducing structural impediments to growth. Finally, the threat to democratic stability and the legitimacy of national democratic institutions would recede, and with it the threat of political populism.

What would be the costs of Grexit for Greece?
A Greek exit from the eurozone would be a step into the economic and political unknown.  An unmanaged exit would cause far-reaching financial and economic disruption. Huge capital flight from Greece would prompt runs on the country’s banks. This would force the newly independent Greek central bank to print large amounts of money to recapitalise the Greek banking sector, which might cause the drachma to collapse in value and lead to very high inflation.  To prevent the gains from devaluation being whittled away by higher inflation, the Greek authorities would have to maintain the political momentum for structural reforms. Many Greek businesses with large foreign currency debts would either be forced into bankruptcy or need to be rescued by the Greek authorities. There would also be pressure from within the eurozone to expel Greece from the EU (legally, a country quitting the currency union must also forfeit EU membership), which would be highly destabilising for a fragile democracy such as Greece.

However, there is a decent chance that Grexit would be a more managed affair involving the pre-emptive imposition of capital controls; the provision of interim ECB support for the Greek banking sector; and the rapid redenomination of contracts – at least those written under Greek law – from euro into drachma.  And although some might be tempted to make an example of Greece, the EU is likely to balk at pushing Greece out of the Union since this could involve Greece defaulting on nearly all of the debt it owed eurozone governments and institutions as well as damaging the credibility of the EU.  However, even under this scenario, the newly-introduced drachma would weaken very significantly. The Greek authorities would have to work hard to establish institutional credibility and hence economic stability, and Greece’s relations with other eurozone governments would be seriously damaged. The short run downsides for Greece could therefore outweigh the potential (but uncertain) future upside.

What about contagion to the rest of the eurozone?
The short-term financial contagion following Grexit would be less acute than it would have been last time it seemed likely, in early 2012. The ECB is now committed to acting as lender of last resort to eurozone governments, eurozone banks are in better shape and there is a rescue fund (however unsatisfactory) in place. In the case of a Greek exit, investors may well test the ECB’s promise to act as lender of last resort, but it should have little problem responding in the required manner.

However, the longer-term risk of contagion could still be serious. A Greek exit from the euro would demonstrate that membership of the single currency is not necessarily forever. This could prompt an increase in borrowing costs for those countries considered at risk of exit, such as Italy. It has been hard for the ECB to start quantitative easing in the face of opposition from a group of members led by Germany, so it is far from certain that the central bank will be able to fulfil its promise to buy the bonds of struggling member-states under its Outright Monetary Transactions (OMT) programme. Moreover, the eurozone has failed to establish proper federal risk-sharing institutions or to write down debt to sustainable levels. In the absence of fiscal federalism, and with intra-eurozone adjustment in relative prices being thwarted by very low inflation in Germany, there are legitimate doubts over the ability of a number of eurozone countries to sustain membership.

Finally, the Greek economy might, after a shaky few months, recover relatively quickly following an exit from the eurozone, as both monetary and fiscal policy boosted demand. Such an economic surge would embolden political forces in other member-states like Italy who favour exit from the currency union. In order to stop this political contagion, the eurozone would have either to make a leap of integration, or throw most fiscal restraints over board and engage in aggressive monetary policy to engineer a proper recovery. Not only are both options hard to conceive in the current political climate. It is also unclear whether that would be enough to keep the eurozone together. The potential risks of Grexit are therefore large for the eurozone.

Does Germany really believe that Grexit would be manageable?
Despite these potentially large risks, both German Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble reportedly believe that the eurozone is strong enough to cope with a Greek exit, as do a host of senior German MPs. But German politicians have the German voter foremost in mind when making public statements. Taking a hardline with Greece plays well, and prevents a further increase in support for the populist Alternative für Deutschland (AfD). In addition, the German government would like the current Greek government to prevail at the general election, and thereby avoid any destabilising confrontation between the eurozone and Syriza. The message that the eurozone can do without Greece is also meant to scare Greek voters into eschewing a vote for Syriza. A very careful politician (and gifted tactician) like Merkel is highly unlikely to run the sizeable risk of contagion – especially since there are other ways to put pressure on a new Greek government.

Do Greeks want to leave the euro?
Greek popular support for the country’s euro membership remains strong. Despite an economic depression that is to a large extent a result of being part of the eurozone and the failure of the troika’s assistance programmes, three-quarters of Greeks say that Greece should stay inside the euro “at all costs”, according to a recent Greek poll. The reason is that there is little trust in domestic political institutions to manage an exit, and a return to a Greek currency, as well as the fear that exiting the euro might mean leaving the EU altogether. No government in Greece will have a mandate to take the country out of the euro. The threat to leave is therefore not a particularly credible one, despite some representatives of Syriza having toyed with the idea in the past.

Three key areas of negotiation
Neither Greece nor the rest of the eurozone has an interest in a Greek exit. As a result, negotiations between Greece and the rest of the eurozone will focus on addressing the following issues:

1. Debt relief

If it wins the election, Syriza hopes to call a debt conference similar to the one held in London in 1953, in which Germany’s debts were cut in half. Syriza has made debt relief a priority, despite it no longer being the main obstacle to economic recovery in Greece: although the ratio of public debt to GDP stands at a very high 175 per cent of GDP, debt servicing costs are moderate because the interest rates on official loans from the EU are low. The EU and Germany are – for a combination of political and legal reasons – unwilling to grant a formal debt restructuring. But the middle ground of some further reductions in interest rates, and further maturity extensions could be the route to compromise.

2. Austerity

Greece’s economic depression has in large part resulted from unprecedented fiscal retrenchment. Syriza has pledged to roll back some of those spending cuts; it wants to run a balanced budget rather than aim for the surpluses demanded by the troika; and it wants to spend €2 billion immediately to alleviate hardship among the poorest. But even these demands seem acceptable: current plans by the troika already entail a slight easing of fiscal policy and a €2 billion programme is modest in size (roughly 1 per cent of Greece’s GDP). The most controversial issue will be the pension system. Greece has already made significant cuts to pension entitlements, but further adjustments will be required because of the depth of the economic crisis.

3. Structural reforms

Some of the troika’s demands, like simpler collective dismissal regulation, could be dropped without harmful effects on the Greek economy. Similarly, judicial reform, the continued overhaul of tax collection (after some progress has been made), and land rights issues could be agreed upon, as Syriza has fewer constituencies affected by those reforms than the current government parties. The overhaul of the public sector would be much more problematic, as Syriza’s supporters are in part disgruntled public employees. The effect of raising the minimum wage, as Syriza plans, is controversial. But given the track record of past governments on structural reforms, even here a compromise with the troika is not out of sight.

The likely outcome
The political game between the troika and a Syriza government will be complex, and periods of brinkmanship are probable. There are some nuclear options for both sides: the withdrawal of liquidity for Greek banks, which the ECB has said it is considering; and the unilateral default on official loans by Greece. However, both sides have an interest in avoiding the nuclear scenario. The rest of the eurozone will have to appear tough in order not to set a precedent for populist parties elsewhere, but it has little interest in precipitating a collapse of Greece’s banking sector. For its part, Syriza would have little choice but to try a find agreement with the troika. It will face a €6-12 billion funding gap in 2015. Even funding for the first quarter of the year is uncertain without official funds, which are  on hold until the troika’s final programme review of the second assistance programme is concluded.

A Syriza victory is unlikely to lead to a Greek exit from the euro, at least for the time being. European policy-makers and Greeks alike might regret Greece’s entry into the common currency in 2001. But divorce would be costly for both sides, and eurozone policy-makers now have too much experience to allow it to happen by mistake. However, this does not mean that the current situation is without risk. The middle ground between the Greek and eurozone positions is small and there is a possibility that the eurozone will not offer enough to satisfy Syriza. This would open the way for political instability in Greece, the outcome of which is hard to predict. Moreover, even if the two sides can reach agreement, they could easily find themselves back at the negotiating table in the near future if the economic and social situation in Greece does not improve.

Christian Odendahl is chief economist and Simon Tilford is deputy director at the Centre for European Reform.

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