‘Grexit’ Could Happen by Accident
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Since the eurozone’s inception, its survival has rested on a paradox. On the one hand, the stability of the single currency hinges on the market’s faith in its irreversibility. It was to restore this faith that European Central Bank President Mario Draghi promised in 2012 to do “whatever it takes” to keep the bloc together. On the other hand, the stability of the eurozone also requires that the possibility of an exit from the euro is real, if only as a way of enforcing discipline among members, particularly those facing financial difficulties.
The current political crisis in Greece is testing this paradox to the limit. No one wants Greece to leave the euro, least of all the Greeks themselves, 74% of whom want the country to remain in the single currency, according to a poll last week. Even the radical leftist party Syriza, which polls suggest will win the Jan. 25 election and which flirted with a policy of euro withdrawal in 2012, now recognizes that “Grexit” would be catastrophic.
Quitting the euro and repudiating existing debts will not magically revive the economy. The government would likely be forced to tighten rather than loosen fiscal policy, as the current small primary budget surplus rapidly turned into deficit amid declining confidence and credit, plunging the country back into recession.
Nor is devaluation likely to bring much respite. Whereas Spain, Portugal, Ireland and Italy have increased exports as they have regained competitiveness, Greek exports have so far received little boost from the country’s substantial internal devaluation. This suggests that structural obstacles rather than prices are what is holding back export growth.
Worse, devaluation would lead to a period of high inflation—possibly hyperinflation, if the government couldn’t borrow to fund its activities or recapitalize the banking system and was forced to rely on the Bank of Greece to print money, undermining confidence in the new currency. Financial instability would deter the foreign investment that is Greece’s best hope of exiting the crisis.
These might be short-term risks worth taking if there were any realistic prospect that a post-exit Greek government might deliver the economic reforms needed. But that seems unlikely: Grexit would be a victory for all those vested interests that have resisted reform in an effort to preserve their privileges.
But just because Grexit would be disastrous doesn't mean it can’t happen. The risk of an accidental Grexit is real.
Greece’s current bailout program with the European Commission, the ECB and International Monetary Fund—collectively known as the Troika—expires at the end of February, after Prime Minister Antonis Samaras secured a two-month extension in December. Whoever wins the election will need to rapidly secure a further extension to buy time to negotiate the long-term deal with the Troika that eluded Mr. Samaras.
A further bailout extension is essential partly because Greece must repay €1.5 billion ($1.77 billion) to the IMF in March and faces more debt redemptions in coming months.
Without a deal with the Troika either to release earmarked bailout funds or to boost its borrowing, Greece might soon find itself forced to default on its debt. Worse, the ECB requires Greece to be in compliance with an agreed bailout program as a condition of the substantial support it is currently providing to the country’s banking system. If the ECB refused to continue to fund the banks, the government would have to issue its own currency to keep the economy from imploding—and Greece would be out of the euro.
Nor is this an idle threat: Greek banks suffered €3 billion of deposit outflows at the end of last year and this trickle could turn into a flood during a prolonged period of uncertainty. The ECB showed in the case of Cyprus that it won’t be deterred by the election of a new government to do what it thinks is necessary to protect its balance sheet.
The risk is that Syriza leader Alexis Tsipras may find the scale of the U-turn necessary for him to strike a deal with the Troika too much in the time available. As a minimum, the Troika will surely insist that he does not reverse the current government’s reforms to the public administration, tax codes, product and labor markets, all of which Syriza opposed. The Troika may also insist Mr. Tsipras commit to the same future reforms that it demanded of Mr. Samaras as a condition for any long-term deal, particularly if Mr. Tsipras is to have any chance of securing his goal of debt relief. Even in the disreputable world of Greek politics, where election commitments can mean so little, Mr. Tsirpras’s credibility could hardly survive such a swift and humiliating climb down.
Eurozone policy makers appear surprisingly relaxed about the risk of failure. Some argue that the eurozone now has plenty of experience at handling such brinkmanship and expect Mr. Tsipras swiftly to buckle when confronted by reality.
Some are also willing to bet that even if he doesn’t yield the eurozone could withstand the shock of Grexit. Greece is better ring-fenced today than in 2012 and the eurozone has more credible weapons to fight contagion, including bailout funds and new ECB facilities, such as a QE program that could start as soon as next week.
Investors seem to share this optimistic assessment, judging by the lack of market contagion to the rest of the eurozone.
But if Mr. Tsipras wins the election, both he and eurozone policy makers will have to tread very carefully to avoid an outcome that no one wants and is in no one’s interest.
The consequences of an accidental Grexit may be far-reaching. After all, it would destroy the necessary illusion of the eurozone’s irreversibility, a shock from which it may struggle to recover.
Write to Simon Nixon at [email protected]