31 May 2012

Douglas J Elliott: Will this Greek Tragedy climax in the death of the euro?

This paper by Elliott for Brookings answers a number of questions about a potential euro exit, looking at i.a. the austerity/growth argument and what the damage of a Greek exit might be.

My personal view is that a Greek exit has a probability in the vicinity 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.

What is the argument about austerity and growth?

Greece is in the fifth year of a terrible recession and most Greeks, and many outside observers, blame excessive and mismanaged austerity measures. Most American analysts, including me, tend to agree that the pace of mandated budget cuts has been unrealistic. However, the German view, supported by some other countries as well, is that it will be impossible for the Greek economy to recover until businesses and households see that the country can put its finances on a sound basis. Further, they believe that Greece has failed to make many of the promised structural reforms and will be even less willing to do so if the pressure is taken off by easing the conditions now.

There is a growing consensus in Europe that the austerity measures in Greece and the other troubled countries may have to be slowed somewhat or offset in other ways. The new President of France, François Hollande, is a particular advocate of this approach and the most important sceptic, Germany appears to be moving towards at least partial acceptance of the ideas. The most likely compromise appears to be for various investment projects to be started or accelerated in the vulnerable countries in order to pump additional money into their economies while hopefully also creating useful infrastructure. The European Investment Bank (EIB) is almost certain to be given additional funding for this purpose, which has the advantage that commitments of capital by the national governments to the EIB are then levered up by EIB borrowings from the markets to supply a greater sum of project loans. There are also discussions of loosening the conditions on regional aid that is provided to Greece and other poorer countries, and possibly redirecting some of the funds towards Greece, in order to increase the amount effectively available in the near- to medium-term. Other investment programmes may well be created in the same vein. The net effect of all these actions, although unlikely to be huge, would be to reduce the pressure on economic growth from the austerity measures.

What would the damage be of a withdrawal by Greece from the euro area?

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 type of withdrawal situation. Therefore, we 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.

Why might other countries exit?

Beyond Greece itself, the demonstration that a country really might leave the euro area raises the possibility that others might also fall out. None of the other euro area nations want to abandon the currency, since they would be subject to the same terrible transition costs and uncertain future benefits that Greece would face. However, there is a real chance of one or more of those nations involuntarily having to withdraw. The very possibility generates self-protective reactions that increase the likelihood of an exit, a phenomenon often called “contagion”, analogous to the spread of a disease. The most obvious feedback mechanism would be a bank run in Portugal, Spain or other countries considered to be the most vulnerable. A run on the major banks in a country could create an untenable situation that eventually results in a withdrawal from the euro.

What can the euro area do to stop further exits?

If contagion from an actual or feared Greek exit from the euro area spreads to other troubled countries in a major way, European leaders would need to react strongly and quickly if they wish the euro not to unravel. If a second nation were also to be forced to withdraw, even one as small as Portugal, the contagion would become so strong that it could well knock out Ireland, Spain, Italy and potentially even France unless extremely strong measures were taken very quickly. Even then, it might be too late. Thus, Europe has a very large stake in preventing any further withdrawals whatsoever, since each one makes the next more likely.

In the short run, the mechanism would be for the ECB, working through the relevant national central banks, to agree to loan the banks in the vulnerable countries unlimited sums at a low interest rate, as long as they can provide collateral to the central banks that meets quite relaxed minimum standards. n the longer run, it would be much better to have guarantee funds and strong bank supervision conducted at the European level. This would take too long to establish for it to directly help with the immediate crises that would be engulfing the troubled countries, but the announcement that Europe would take these steps would still be helpful as a sign of the full commitment of stronger national governments to help the weaker... In the longer run, it would be much better to have guarantee funds and strong bank supervision conducted at the European level. This would take too long to establish for it to help directly with the immediate crises that would be engulfing the troubled countries, but the announcement that Europe would take these steps would still be helpful as a sign of the full commitment of stronger national governments to help the weaker.

These steps to aid the vulnerable banks would be necessary in order to reassure everyone that the banks could survive the turmoil. Unfortunately, such steps do not deal with the central fear that depositors might end up owning pesetas when they thought they owned euros. Thus, Europe would need to send very strong signals that there would be no further exits from the euro and no further need for such exits. This might well require commitments to fund Spain or Italy if the financial markets ceased to be willing to provide the money at sustainable interest rates. 

In the extreme scenario, there would be a series of exits, leaving only the stronger countries still in the euro. Those that pulled out would experience deep recessions, even depressions, as they suffered the transition costs of exit and dealt with the implosion of their banking sectors and much of their business community. They would also wrestle with high inflation. On the positive side, their export situations could improve considerably due to massive devaluations, once things eventually settled down, unless fully offset by higher inflation or other problems.

Those nations that remained in the euro would suffer the knock-on effects of the troubles in the rest of Europe, especially since much of their exports go to those countries, whose purchases would fall off dramatically for at least awhile. As things settled down, they might find that the value of the euro appreciated substantially, without the drag from the weaker countries, hurting exports of the remaining euro area on a more permanent basis.

Having laid out the most dire scenario, I should emphasise that there are many ways in which the euro area might avoid getting to that point. This includes the likely possibility that even Greece will pull back before getting to the point where it would exit the euro, especially as the large majority of the public wants to avoid leaving the euro area.

Full article

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