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.

German Bond Rates Go Negative

The stagnant European economy does not need more bad news. Unfortunately, there is more coming. Business Insider reports:

The amazing collapse in German bond yields is continuing. Today, five-year bonds (or bunds) have a negative nominal return for the first time ever. That means that investors buying a 5-year bond on the market today will effectively be paying the German government for the privilege of owning some of its debt. This has been happening for some time now. In 2012, people were amazed when 6-month bund yields went into negative territory. In August, the two-year yield went negative too. Less than a month ago, the same thing happened with the country’s four-year bunds.

While there is a downward trend in bond yields in most euro-zone countries, there is a clear discrepancy between first-tier and second-tier euro states. Ten-year treasury bond yields, other than Germany:

  • Austria, 0.71 percent, trending firmly downward; France, 0.83 percent, trending firmly downward; Netherlands, 0.68 percent, trending firmly downward; Italy, 1.87 percent, trending firmly downward.

A couple of second-tier examples:

  • Ireland, 1.24 percent, trending weakly downward; Portugal, 2.69 percent, trending weakly downward.

Greece is the real outlier at 9.59 percent and an upward yield trend. But Greece is also a reason why Germany’s bond yields are turning negative. Although the Greek economy is no longer plunging into the dungeon of depression, it is not recovering. Basically, it is in a state of stagnation. Its very high unemployment and weak growth is coupled with an ongoing austerity program, imposed by the EU, the ECB and the IMF.

Add to that the political instability which, in late January, will probably lead to a new, radically leftist government. Syriza’s ideological point of gravity is the Chavista socialism that has been practiced in Venezuela over the past 10-15 years. They are also vocal opponents to the EU-imposed austerity programs, an opposition they would have to deliver on in case they want to stay relevant in Greek politics.

If Greece unilaterally ends its austerity program, it de facto means the beginning of their secession from the euro. That in turn would raise the possibility of other secessions, such as France, where a President Le Pen would begin her term in 2017 with a plan to reintroduce the franc. When that happens, the euro is history.

There is no history of anything similar happening in modern history, which makes it very difficult for anyone, economist or not, to predict what will happen. Europe’s political leaders will, of course, want to make the transition as smooth and predictable, but without experience to draw on there is a considerable risk that the process will be neither smooth nor politically controllable. Add to that the inability of econometricians to forecast the transition; based on the numerous examples of forecasting errors from the past couple of years, there is going to be little reliable support from the forecasting community for a rollback of the euro.

That is not to say the process cannot be a success. But the window of uncertainty is so large that it alone explains the investor flight to German treasury bonds.

This uncertainty is also throwing a wet blanket over almost the entire European economy, an economy that desperately needs growth and new jobs. Since 2010 the EU-28 economy has added 800,000 new jobs, an increase of 0.37 percent. For comparison, during the same time the American economy has added eleven million jobs, an increase of a healthy 8.5 percent.

Euro Breakup Coming Closer

I have been predicting a Greek exit from the euro for a while now. I have also noted that other countries with much better credit rating, primarily Finland, have been floating the idea of leaving the euro because they don’t want to be contaminated by the Greek mess. This has, as I have explained, put a lot of tension on the euro, and essentially forced pro-euro nations like Germany to choose whether or not they want to be part of a weak currency, or a strong one.

It looks like the Germans have now made up their minds. According to the EU Observer the Germans have already begun engineering the Greek secession from the common currency:

Greek prime minister Antonis Samaras has called on EU politicians to stop unhelpful speculation about his country’s exit from the eurozone but his plea comes as it emerged that German officials have set up a ‘Grexit’ working group.

Not surprisingly, this does not sit well with the Greek prime minister, who says that…

efforts to undertake the tough reforms demanded by Greece’s lenders are being undermined by regular negative statements about Athens’ euro future. “How can we privatise when, every day, European officials speculate publicly about a potential exit of Greece from the common currency? This has got to stop.” Samaras said an exit from the eurozone would be “devastating” for Greece as no democracy could survive such a drop in living standards but also for other eurozone countries who would feel sharp knock-on effects.

Well, to begin with the Greeks have not exactly been working to build their own standard of living. Their idea of “standard of living” has been to milk as much as they could out of government and then use a German-backed credit card called the common currency to get cheap loans for their lavish fiscal self-indulgence. Mr. Samaras is not the right person to lament about a drop in the standard of living.

Beyond that, he does have a point in that the speculations about a Greek exit contradict his efforts at putting austerity to work in his country. From an outsider’s viewpoint this looks like the EU and Germany don’t believe in their own deal to save Greece. But this contradiction is problematic only to the extent that one believes that the austerity imposed by the EU actually could save Greece. It can’t. In fact, the austerity measures are pushing Greece closer and closer to a breaking point where the country will ditch both the euro and its parliamentary democracy.

Therefore, Mr. Samaras’ complaints, while valid within a narrow context, are more reflective of his overall frustration of where his country is going than part of a genuine effort to save Greece. If he really wanted to save Greece he should end the austerity bombardment of the country’s economy and focus on structural reforms that will permanently roll back the welfare state.

As the EU Observer notes, Samaras is in Berlin to negotiate easier terms on the austerity programs demanded by the EU and Germany, but his reason for doing so has nothing to do with getting time to reform away tax-funded entitlement programs. His only goal is to avoid uncontrollable escalation of an already tense political and social situation in Greece:

Samaras will meet Chancellor Angela Merkel in Berlin Friday (24 August) to put the case for more flexibility around the austerity programme demanded by creditors in return for the second €130bn bailout. He said the meeting would not be about discussing the goals of the programme but how to achieve them while maintaining “social cohesion.” However his visit coincides with news that the German finance ministry has established a special working group to discuss how to deal with a potential Greek exit from the eurozone. Financial Times Deutschland revealed that the group … is considering the “financial consequences” of an exit and how to prevent a “domino effect” to other states, the newspaper quotes a ministry official as saying.

The German government is strongly pro-euro, and its overall attitude is that Greece is an anomaly within an otherwise well working currency union. That is not the case: once Greece goes, it will be proof that the efforts to stabilize fiscally troubled countries within the euro zone do not work. Spain is currently undergoing the same treatment as Greece, though at an earlier stage. If Greece secedes, it will ony be a matter of time before a Spanish exit becomes reality.

What makes this situation so delicate is that the only way to save the euro is to kick out countries like Greece and Spain. But if that becomes the norm, it will set an entirely new and very low tolerance level toward fiscal problems in the remaining euro countries. It will reinforce the calls for a common fiscal union for the euro countries – a federal government running the entire welfare state in all nations with the euro as their currency. This new level of “integration” does not sit well with EU critics and those who want to preserve national sovereignty in Europe. It should therefore come as no surprise that a new, anti-euro movement has seen the light of day in Austria. EurActiv reports:

Billionaire auto parts magnate Frank Stronach has burst into Austrian politics with a call to abandon the euro, probably turning parliamentary elections due next year into a de-facto referendum on the country’s role in Europe. The man who emigrated to Canada as a 22-year-old pauper and made a fortune by building the Magna automotive supply empire has come home with a bang, insisting it is time to restore the schilling national currency as quickly as possible. Stronach’s party is so new that it still has no name and its support remains so far in single figures, but the 79-year-old is already drawing on the discontent about the cost of eurozone membership which is spreading in the bloc’s wealthier members.

Which again should not surprise anyone. The Finns have, as mentioned, already voiced the possibility of them returning to their national currency, the markka, if the euro continues to weaken from the perpetual problem countries down south. Austria is also a well-managed country, by European comparison, and, like Finland, a relative newcomer in the EU (the two joined in the mid-’90s together with Sweden). Being a strong economy, Austria finds itself…

having to fund bailouts for the eurozone’s weaker members. There is increasing evidence of bailout fatigue in the well-off countries, so having solidly pro-Europe Austria waver in its commitment would be an ominous sign for the currency. Finland’s foreign minister said last week that officials had prepared for the possible collapse of the single currency. Dutch voters go to the polls next month in an election dominated by the eurozone debt crisis and austerity measures. “Clearly this is not just an Austrian development but more representative of the so-called stronger countries which have the highest credit rating,” said Zsolt Darvas, research fellow at the Brussels-based Brugel think tank. “In Germany, Finland or the Netherlands you see exactly the same or similar movements.”

Interestingly, EurActiv reports that the concept of a euro rollback has set roots in national politics:

[Austrian] FPÖ leader Heinz-Christian Strache, whose party is off highs but still gets around 21% in polls, is calling for the eurozone to be reduced to a group of strong members such as Germany, Austria and the Netherlands. Even ÖVP leader and Foreign Minister Michael Spindelegger, a pro-Europe stalwart, has backed treaty changes to let the eurozone evict members that do not live up to financial commitments.

Whenever the Greek exit from the euro happens, it is going to be a tumultuous moment. It may turn out to be a bit of a fiscal blessing for the rest of Europe who can experience some easing of austerity policies – which they should use to start phasing out their welfare states, not rebuild them – but the problems in Greece will not go away. Their return to the drachma will in all likelihood cause a dramatic plunge of the currency, which in turn will lead to a serious spike in import-price inflation. The country will have scant opportunities to borrow on its own, which will force them to yet again choose between austerity, the welfare state – and ultimately the very democratic system of governance.

Other European countries are not that close to the abyss. Spain is experiencing political turmoil and some signs of social instability, though not yet at the level we can see in Greece. Nevertheless: the Greek experience is a stark warning to the rest of Europe: it’s time to wake up and do something about the welfare state – or else, you will follow in the Greek footsteps.