By Douglas J. Elliott, Brookings Institute
Greece could well be out of the euro soon, depending on the results of the election scheduled there for June 17th. An exit would inevitably be messy and would likely push Europe into a severe recession, the U.S. into at least a modest recession, and to substantially slow the growth of China. The Institute of International Finance has estimated an exit could cost the world economy over $1 trillion and official bodies such as the International Monetary Fund (IMF) have similarly warned of disastrous results.
Part of what makes this so scary is that it is impossible even to accurately estimate the probability Greece will exit, much less know for sure whether it will. Analysts at investment banks are estimating probabilities of a euro exit by at least Greece that cluster around 50%, the traditionally safest percentage to choose when there is a serious likelihood of something happening, but no real way to assess the probability. Various economists and political analysts give opinions ranging from an exit being “inevitable” to “very unlikely,” strongly influenced by whether they view the euro experiment as fundamentally unsound or simply experiencing growing pains.
My personal view is that a Greek exit has a probability of perhaps one in four or five, certainly higher than I have estimated in past months but still reflecting my belief that an exit would be harmful for both Greece and Europe as a whole and therefore will be avoided.
The leading Greek parties all support staying in the euro, as do about three-quarters of the voters. However, an almost equally large majority support parties that favor a rejection of the existing bailout agreement because they believe it has too many cuts in government spending and reductions in labor market and other protections. The problem is that rejecting the bailout agreement is likely to be incompatible with staying in the euro, forcing a choice between these two strongly held views.
The Greek government spends considerably more than it takes in, with Europe and the IMF funding most of the difference. Greece secured that assistance by agreeing to impose tough measures. If a new Greek government rejects the bailout agreement and subsequent negotiations fail, Europe may pull the plug on this funding and on the liquidity assistance that has kept the Greek banking system alive. There are a number of ways in which this dire situation could lead to an exit from the euro.
The elections will be the key to whether Greece exits the euro, at least in the short to medium term. New Democracy and PASOK, the two parties that traditionally dominated Greek politics, support the broad terms of the bailout package which they had signed on to. Syriza is the leading rejectionist party, although most of the political spectrum wants to renegotiate the terms. New Democracy and Syriza are running neck and neck, with the former holding a slight lead in the last polls before a polling blackout kicked in two weeks prior to the election. The party with the most votes gets a 50 seat bonus in the 300 seat parliament and is likely to be able to form a workable coalition.
If New Democracy wins, it will form a coalition with PASOK, and is highly likely to be able to find a workable compromise with Greece’s European funders, although it admittedly will be very tricky to do. If Syriza wins, it will almost certainly play a game of brinksmanship, trying to force Europe to agree to dramatically more favorable terms for Greece by effectively threatening to let the Euro fall apart. This is a plausible threat because if Greece pulls out of the Euro, it will make it considerably more likely that Portugal or another troubled country will be forced out as well, making further exits even more likely, in a domino effect of disaster. Greece would be hurt badly by a withdrawal, but it would not suffer alone, so it hopes that the threat of disaster will force the hand of its European partners.
Why would Greece be badly hurt by a withdrawal? Whatever the medium to long run advantages and disadvantages for Greece in returning to its own national currency, few seriously dispute that the Greek economy would be badly damaged in the near-term. There is no legal mechanism for withdrawal from the euro without also withdrawing from the European Union and even that procedure would take much longer to negotiate than would actually be feasible in this situation. Therefore, we would find ourselves in uncharted legal waters where the Greek and other governments would be making ad hoc decisions and trying to negotiate to limit the damage. This guarantees a huge amount of uncertainty that would weigh heavily on the Greek economy. Few businesses or individuals would dare to invest in Greece in the short run and everyone who could do so would increase their precautionary savings by cutting expenditures to the bone, and there would be huge incentives to move funds out of Greece, despite capital controls that would undoubtedly be put in place.
Many corporations and some individuals would also be bankrupted by the resulting exchange rate movements. The new currency would plunge in value compared to the euro. Anyone who owed money to non-Greek parties in euros could well find that they have to repay that debt with much-depreciated drachmas, making their debt burden much bigger. External financing would also virtually halt, adding to the credit squeeze. Political uncertainty would add its own cost, as there is a considerable likelihood that any government that pulled out of the euro and inflicted these transitional costs on the Greek public would be thrown out of office. All of this, and the riots that might also occur, would be likely to smash the tourism business for some time until relative stability is restored.
In the longer run, a depreciated drachma could make tourism in Greece and exports to other countries much more attractive, allowing Greece to regain access to foreign funds by running a trade surplus. I write “could” because it depends heavily on what else affects the prices and quality of exports and of tourism. In particular, inflation would almost certainly shoot up initially, triggered by rising costs of imported goods, erasing some of the advantage of the price reduction for exports created by the exchange rate movement. Costs would also rise because interest rates would soar due to high inflation and fears of future inflation. In theory, it would be possible for the major segments of Greek society, including the unions, to develop a wage-price policy that would ensure that exports did indeed become more competitively priced. However, this is difficult to do under the best of circumstances and Greece would be trying it under the worst.
The upshot is that Greece, Europe, and the rest of the world, including us, really needs a compromise to be reached. Our very strong mutual need to avoid disaster is my biggest hope for an acceptable solution. However, sometimes the right course can be politically impossible, especially in a situation as complicated as this. In that case, it will pay to be very conservatively invested, because almost anything that carries some risk will go down in value.