02 June 2015

Brookings: Greece is riskier than the markets seem to think

Such an exit would do serious harm to Greece, as I have written previously, and would damage the rest of Europe to a more modest extent. Markets seem complacent about the probability and risk of a Greek exit. The actuality should lead to significant increases in the required yields for borrowers in Portugal, Spain, Italy, and anywhere else that there is a possibility of an eventual exit from the Euro, however unlikely it seems in the near-term. Once the barrier to exit has been breached, the possibility of more departures in the years to come must be taken seriously and that should be reflected in the required interest rates. These rate increases would reverse many of the benefits of the ECB's quantitative easing program, which has helped restart the European economy.

This is not to suggest a panicked over-reaction by markets, though. My base case remains that Greece will work out a deal with its creditors, either prior to, or shortly after, a temporary default. Further, the Eurozone is in a much better position to handle the effects of a Greek withdrawal than it was. A Greek exit would not turn out to be a "Lehman moment" when the world falls apart, although there would certainly be some negative surprises as we discover economic and financial links that we had not focused on. Both sides would be well advised to avoid a Greek exit, and they probably will, but Greece would be damaged much worse than Europe as a whole if the negotiations go wrong. As for the U.S., we would be adversely affected as well if things go very wrong, but the consequences for us would be much less.

My view is more pessimistic than it was earlier. Two weeks of meetings in Europe have convinced me that the potential for a very negative outcome on Greece is higher than I thought and that it is very difficult to analyze the risks, which argues against complacency. Adding to this, the favorable turn that had seemed evident in negotiations has been replaced by a noticeable hardening of positions. The major analytical difficulties, and the big real-world risks, center on Greek politics. Here the answers are simply unknowable. The vast majority of analysts, myself included, do not have a deep understanding of Greek politics. Worse, even the savviest follower of Greece cannot reliably guess what will happen in a situation that is completely novel.

The big question is whether Greece will be able to secure a short-term deal with its European funders that will buy everyone a few months to begin negotiating for the longer-term. By late July, Greece will be unable to make payments to the ECB and other official creditors, if it does not run out of funds before then. (This could happen as early as the next couple of weeks, as payments to the IMF come due.) If there is a breakdown in negotiations and a default, even a temporary one, there will be deposit runs on Greek banks that will almost certainly force the government to impose capital controls and limits on bank withdrawals. The confidence shock to the economy, combined with the practical harm from such controls, would quickly send the nation into a serious recession, unless a deal is struck quickly to reverse the default and secure European funding.

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In short, there is still likely to be an eventual deal to avoid the worst outcomes, but the probabilities of disaster are too high to justify the nonchalance the European financial markets are showing. The very fact that we are arguing about Greek political outcomes demonstrates the riskiness of the situation.

Full article on Brookings

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