Wider contagion remains greatest risk of Greek exit
SOME form of Eurozone break-up seems more and more likely. Austerity can’t work without growth, of which there is no prospect for the Eurozone’s peripheral economies. With recessions set to deepen, fiscal targets will become even more difficult to achieve. It is now close to a consensus view that political deadlock in Greece will mean that it fails to meet the conditions for future instalments of its bail-out, and will be forced out of the euro.
A Greek exit would entail the reintroduction of the drachma, a sharp devaluation and even bigger defaults by its government. Greece would redenominate all domestic prices, wages and contracts and would likely declare a bank holiday to avoid a bank run. Then, the drachma would depreciate sharply, perhaps by 50 per cent or more.
The government would probably insist that its international debts were redenominated in drachmas. Given the relative weakness of the currency, this would amount to a default by another name. But as it would now receive tax revenues in drachmas, debts denominated in euros would just not be affordable. The private sector would probably be legally unable to redenominate its debts. But it couldn’t possibly service them if they were owed in euros and hence mass defaults and bankruptcies could be expected.
The direct effects may not be catastrophic for the Eurozone. But the pivotal issue remains that of contagion. If a Greek exit is seen as the first step in the unravelling of the currency union, the economic and financial consequences would be extremely severe. Accordingly, everything hangs on what actions the policymakers are willing and able to take to prevent that process.
It seems clear that the existing “firewalls” aren’t enough. Current Eurozone bail-out funds, and the IMF’s resources, amount to about €1 trillion. While this is enough to meet Italy and Spain’s needs until the end of 2014, it falls short of the amount needed to “backstop” the Spanish and Italian bond markets. The threat of a complete collapse of the euro could prompt policy-makers to more decisive action to keep Spain and Italy in. But there is a growing risk of a bigger break-up.
Even assuming that the break-up is limited to two or three countries, consequences for the Eurozone will be serious. At Capital Economics, we see the region’s GDP falling by roughly 1 per cent this year and 2.5 per cent in 2013. Others in Europe will suffer most, given trade and financial linkages. The region is the destination for roughly half of the UK’s exports, for example.
Yet there might be light at the end of the tunnel. Once peripheral economies have devalued, they will stand a chance of achieving some growth. Within a smaller, stronger Eurozone, there’s a greater chance that Germany will rebalance away from exports and towards consumer spending. Both of these factors could markedly improve the prospects for what is now the Eurozone and hence benefit the global economy in the long run.
Jennifer McKeown is senior European economist at Capital Economics.