Blackmail by Athens?

Last week rumours circulated that Greece is considering leaving the eurozone. In addition, representatives of the European Commission and European finance ministers apparently held a secret meeting to discuss the country’s future. Although the possibility of Greece exiting the eurozone has been strongly denied by officials in Brussels and Athens, the timing of the news was certainly no coincidence.

One year ago, the Greece lost the confidence of the financial markets, interest rates rose dramatically, and the Greek government asked for help from other euro area countries. Since then, the Greek state has been dependent on capital supplied through the European rescue package. The loans are conditional on a significant fiscal consolidation. Moreover, structural reforms to modernise the countries are demanded. So far, the very unpopular fiscal consolidation has been ‘broadly on track and has made further progress towards its objectives’, as stated by the European Commission in February 2011. Therefore, the rumours of a possible euro exit were quite surprising. Of course, with a national currency Greece could easily depreciate against the euro to gain competitiveness. But what would a euro exit really mean for Greece and the euro area?

Let us suppose Greece tried to exit the euro. What would happen? First, just after the announcement of an exit, investors and private savers would transfer their euro-dominated money out of Greece or would hold cash in euros. This capital flight to prevent an anticipated depreciation loss would immediately make all banks in Greece illiquid and insolvent. Moreover, the depreciation would increase public and private debt (which would still be denominated in euros). Within days or weeks a large part of the private sector and the Greek state would default on their debt. That could potentially drag the euro area as a whole into recession and would almost certainly threaten the stability of the euro area banking system. The costs of a euro exit by Greece would be immense and would be borne by all euro area countries. Thus the exit option is certainly not in the interest of the euro area.

So, how did the exit rumours start? Greece is probably preparing to renegotiate the conditions of its loans because the Greek deficit will certainly not decrease as proposed one year ago. More loans will be necessary and for a much longer period. As official documents of the European Commission tell us that everything is ‘broadly on track’, it seems that either the rescue programme was not the right way to help Greece (see my blog post from May 2010: ‘Euro stabilisation plans are flawed’) or Greece is not doing enough fiscal consolidation. In this context, is raising the possibility of exiting the eurozone effectively blackmail from Athens to increase financial support from other members?

If yes, it is poor blackmail, particularly if one considers further the effects of exit on the Greek economy. I wonder who would accept the new drachma, which has no credibility and is issued from a country that has just defaulted. The new drachma would heavily inflate after depreciating against the euro and many Greek citizens would probably continue to use the euro, as it is the more valuable currency (there are already signs that Greeks are withdrawing euros from their bank accounts). Banks or foreign investors might only provide loans (if any) in euros to prevent the high exchange rate risk. To a large extent, Greece would be ‘euroised’, and accordingly such a blackmail strategy is not credible.

Exiting the euro looks at first glance like a simple solution that solves almost all the problems of the now euro-trapped Greece. But the costs for Greece and the euro area would be immense, while the benefits would be minor. Greece should therefore stick to its fiscal consolidation programme. A restructuring of the debt might also help. However, more important are structural reforms to increase labour market flexibility and untangling free markets to promote private enterprise, innovation and economic growth.

Broadly agree with your analysis, though I think you come close to saying that the euro could never be broken up because of the Armageddon-style consequences. It may be improbable but other currency unions have broken up in the past and in economics it is wise never to say never!
As I suggested in my Wall Street Journal article, one way to deal with this is to simply remove the requirement for the euro to be monopoly money and allow the Greek government to issue drachma again if it wished (or any private issuer to issue money). All contracts currently written in euro should remain written in euro. Obviously, I do not accept the argument that countries benefit from permanently weak currencies but it is certainly the case that fiscal retrenchment is more painful (if markets are tightly regulated) on fixed rather than on floating exchange rates.
You are right to suggest the best way for Greece to emerge from this is to tackle its structural rigidities, by removing government control from the productive economy (privatisation), by reducing labour-protection laws to encourage flexible (ie competitive wages) and hence employment; and by rekindling a spirit of enterprise that aincludes a willingness to pay taxes. These are all good things, but to achieve them will take some time, years - if not decades. This is not a country which has declining industries, which neeeds to find something to take over from "rust-belt" businesses or the like. The reason the Greeks are - possibly - threatening to exit the euro (behind the scenes) is exactly the same reason Germany is currently saying Greece gets no more money unless it meets agreed conditions, and sets stringent new ones. That reason is that at present the only solution the politicians can envisage is the fiscal-transfer that is oft mentioned, but not explicitly stated. Germany et al are tapping up their taxpayers for vast sums to keep countries such as Greece afloat, but have absolutely no guarantees - and could not enforce any guarantees - that Greece is a good bet, now or any time in the future. In realitly, the bullet should be bit, another solution encompassing the ideas you mention should be devised, and an "orderly" - i.e. open and fair restructuring should take place. In the absence of viable solutions, Greece is just negotiating the best price for its overdraft, with the lenders seeking to ensure it will pay them back. Nothing being said at the moment gives any indication this will be so. The game being played is merely a side-show to the real thing, which will encompass (probably) all the things you mention as the downside to exiting the euro, just at a later date.
Clearly the Greek government is unable to meet its liabilities, so some kind of 'default is inevitable -- though the politicians will no doubt do their best to use a more emollient word. The real problem, though, is with the eurozone itself. The consequences of a Greek default would admittedly be serious; but after all Greece is just one small country and governments have defaulted before and will again. If, however, Greece were to leave the eurozone, attention would immediately shift to Portugal, then to Ireland, then to Spain, etc. The consequence would presumably be a break-up of the eurozone. Such an outcome would no doubt be highly inconvenient politically for the eurocrats and for France and Germany in particular, who have invested so much in the whole EU project. But many people -- including Donald MacDougall -- did point out in advance that the eurozone didn't look anything like an 'optimal currency area', so it is difficult to pretend one is surprised by the current turmoil. Even if German taxpayers could be persuaded to subsidise the Greek government until kingdom come -- which seems unlikely -- even they will surely not be prepared to subsidise Portugal, Ireland, Spain et al. indefinitely too. By the way, it is by no means certain that the British government will be able to avoid eventual default, though that can hardly be blamed on the eurozone.
Privatising the energy sector would be a good start. Along with public broadcasting.
Sorry but the article and the subsequent comments miss one crucial point: Its all the bankers fault and if we increase bank taxes then pretty soon we will dock in the merry port of Nirvana. Call yourselves ecnonmists???? Only Gordon B can save us.
Reply to last comment Gordon brown style politics got us into this brown mess. It happened under his watch. Bankers did not create government debt. And they do not create government spending. The do sometimes loan money to governments.
Matthew, there was no need to reply to the kite-flier Anonymous - I can only presume you are an "econmist", and felt you had to respond. Your suggestions regarding selling state assets are entirely valid, and of course are being pursued to some degree; Anonymous' idea that this can all be resolved by taxing banks is too ludicrous to warrant a response - which banks? Greek banks? Or would Anonymous seek to support EU politicians by foisting Greek problems on the taxpayers in other countries via their banks? I suspect Anonymous has turned up here by mistake, a refugee from a lesser blog, or the comment section of a daily paper. Certainly the terseness, paucity of thought and bad spelling don't fit with this site.
On Greek default gentlemen you aren't thinking big enough :) "Let us suppose Greece tried to exit the Euro. What would happen?" Now, why would they announce they're exiting? Thus giving agents time to leave, really - it looks the way you demonstrate very stupid ot the authorities, to warn anyone - before the exit is happening and it's to late for anyone to leave. *If Greece intends to leave, they will plan that in absolute secrecy. *Once prepared, they shall implement the change over a weekend. *The first anyone shall know it's happening, will be an announcement, that all movements of capital have been frozen - illegal so who cares, we're talking about the actions of the desperate. *In the same announcement, it shall be announced that all money within the financial system of Greece, with zero exceptions, have been changed into new Drachmas, on one to one basis. *You shall be able to take you cash, in new Drachmas only - sorry for the inconvenience, and that you shall not be able to do anything with those new Drachmas outside of Greece. *Bankruptsies, well - in order to keep thing operating, a one year stay shall be imposed, so no legal action against firms operating, because they're bankrupt, shall be possible - similar stay shall be imposed on mortgages. *If considered necessary, stay can be extended on one by one year basis. So, yes default - not just of the state but of the wider society on their loans. ------------------------------ The actions must be secret, to prevent wholesale flight of money. Greetings.

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