When Greece Leaves the Euro

Greece keeps pushing the currency union envelope. Mr. Tsipras, the socialist prime minister, is driven by his ideological convictions and therefore plays a different game than the leaders in Brussels with whom he is negotiating to keep his country afloat. The problem for the European leadership is that it seems incapable of understanding what role Tsipras’s ideology plays for his actions – Tsipras wants full independence for Greece so he can build his version of the socialist dreamland that now-defunct Venezuelan president Hugo Chavez created.

Rational arguments such as “property rights no longer exist in Venezuela” or “they have 60 percent inflation” and “crime is rampant and there is a shortage of almost every daily necessity” do not work on ideologues like Tsipras. That is the very problem with them. Therefore, you cannot reason with them as though they were swayed by the same type of “sensible” arguments that you are. But more importantly: so long as the EU leadership does not understand that politicians like Tsipras are ideologically opposed to everything that the EU stands for, they will not be able to have a rational conversation. There will be constant discords, where the EU leaders try to set goals that will help Greece stay inside the euro zone – and ultimately the EU – while Tsipras and others like him (think euro skeptics in Italy and Spain) will try to create circumstances that allow them to get what they want, namely out of the euro zone (and eventually the EU).

The biggest danger with this discord is that once the euro zone starts breaking apart, the retreat from the common currency will be disorderly. There is no doubt that the Bundesbank in Germany has a contingency plan for that disorderly dissolution, but it is far from certain that their plan will work. There are so many uncertain factors in this game that an even reasonably confident prediction is out of the question.

That said, there are some fixed points that can be put in the context of macroeconomic reasoning. That in turn should at least provide some insight into the best and worst case scenarios.

Before we get there, though, an update on the Greek situation, as reported by the EU Observer:

The stand-off between Greece and its lenders deepened over the weekend ahead of a meeting of euro finance ministers on Friday (24 April), with both sides exchanging barbs over the risk of a Greek default and its consequences for the eurozone. On Friday, Eurogroup president Jeroen Dijsselbloem said both parties should avoid “a game of chicken to see who can stick it out longer. We have a joint interest to reach an agreement quickly”.

An agreement about what? If Greece secedes from the euro it can, at least theoretically, run away from its bailout-related deals. In practice, the EU would still want to enforce loan contract, but it is much more difficult with a country that has a currency of its own – a currency that in all likelihood will be depreciating rapidly.

As for the IMF, Greece would have to deal with them separately, but it could do so much more so on its own terms once outside of the euro zone.

In fairness, though, it looks like the full extent of the Greek situation is beginning to dawn on at least some EU leaders. The EU Observer again:

EU and International Monetary Fund (IMF) leaders warned that Greece had to make quick progress to finalise a list of reforms that would enable it to receive a €7.2 billion loan. But they hinted that a Greek default could be managed by the eurozone. “More work, I say much more work is needed now. And it’s urgent,” said European Central Bank (ECB) chief Mario Draghi in Washington, where he was attending the IMF’s Spring meeting. “We are better equipped than we were in 2012, 2011, and 2010,” he added, referring to the years when fears of a eurozone break-up were at a high. “Having said that, we are certainly entering into uncharted waters if the crisis were to precipitate, and it is very premature to make any speculation about it,” Draghi also said.

So what would happen if Greece seceded from the euro? Well, the EU Observer article brushes on that subject:

Greek finance minister Yanis Varaoufakis, for his part, warned that his country’s exit would cause major problems for the rest of the region. “Some claim that the rest of Europe has been ring-fenced from Greece and that the ECB has tools at its disposal to amputate Greece, if need be, cauterize the wound and allow the rest of the eurozone to carry on,” he said on Spain’s La Sexta channel “Once the idea enters peoples’ minds that monetary union is not forever, speculation begins … who’s next? That question is the solvent of any monetary union. Sooner or later it’s going to start raising interest rates, political tensions, capital flight.”

This is a key statement. Some would interpret it as Greek leverage in negotiations with Brussels. However, the correct way to read it is as a blunt warning of what is to come: sooner or later Greece will leave the currency union, and it will do so like the men who escaped Alcatraz in 1962. Once someone has done what everyone thought was impossible, then just as Mr. Varaoufakis says, the only question on everyone’s mind will be: who’s next?

British Member of the European Parliament for the UKIP, Mr. Nigel Farage, made a great point recently when appearing on BBC (at about 2:25 into the video): the initial effect of a Greek currency secession is going to be a boost in growth as the currency depreciates. This growth spurt will inspire other struggling euro-zone states to consider a return to their national currency. Once the secession movement gets off ground, it is uncertain how many states will actually reintroduce their national currency, but it would be reasonable to expect a first round of secession to sweep from Athens to Lisbon.

The short-term financial turmoil aside, the most likely effect will be a southern European currency war. The four countries that have historically had weak currencies will find themselves returning to that position, only with an even deeper macroeconomic ditch to climb out of. The only moving part of their economies is, actually, exports, which will get a boost from a rapid currency depreciation. At the same time, that depreciation will be a major conduit for imported inflation, which in turn will eat its way into the economy a bit after the exports boom has gained momentum. The more the currency depreciates, the stronger the imported-inflation effect will be.

Inflation will have major consequences for the government budget. Depending on what type of inflation indexation is built into the welfare state’s entitlement programs, the cost of government spending will rise more or less with inflation. While inflation can also be beneficial to the revenue side of the state budget, it negatively influences the purchasing power of households and generally (but not always) depresses business profitability. As a result, domestic economic activity slows down, causing the tax base to stagnate.

And this is where the major test comes for currency secessionists: how will they handle their budget problems? With weak currencies they will have a hard time selling their treasury bonds on the international market; they can load up their banks – a likely scenario in Greece where a Syriza government could even go as far as to nationalize banks – but as the Great Recession demonstrated, leaning on banks for funding a government deficit is a particularly bad idea. When banks are overloaded with bad government debt in the midst of a macroeconomic crisis, then suddenly it is 2009 again.

Very briefly, then: once the euro zone starts falling apart the first ones to leave will face very difficult challenges. That is not to say that the remaining euro zone countries will have a better life – it is very likely that the euro zone itself won’t survive the 2017 French presidential election – but once the Southern Rim has left the euro zone the remaining countries will have a somewhat easier time following an orderly retreat plan. In fact, it would not be surprising if Germany, Austria and the BeNeLux countries remained in a “core” currency union – a Gross-Deutsch Mark, if you will. That currency could actually become a stabilizing point for a post-euro EU.

Still, even with an anchor currency in the heart of the EU, an implosion of the euro will have major negative effects for the European economy. What will those effects look like? That is a subject for another article.