The Costs of Grexit
Earlier last week, following days of tense discussions, the new government in Athens reached an agreement with its eurozone creditors that includes a package of immediate reforms and a four-month extension of the financial assistance programme. But, despite Europe’s collective sigh of relief, the compromise does not preclude the need for further tough negotiations on a new financial-assistance program that should be introduced by the end of June.
In any negotiation, a key variable influencing the protagonists’ behaviour, hence the outcome, is what failure to reach an agreement would cost each of them. In this case, the issue is the cost of Greece’s exit (“Grexit”) from the eurozone – a prospect that was widely discussed in the media throughout the recent negotiation, with considerable speculation about the stance of the various players, especially the Greek and German governments.
From Greece’s perspective, leaving the euro would be highly disruptive, which explains why there is very little support for it in the country. But what about Grexit costs for the rest of the eurozone? Ever since the question was first raised in 20112012, there have been two opposing views.
One view – dubbed the domino theory – claims that if Greece exited, markets would immediately start wondering who is next. Other countries’ fate would be called into question, as occurred during the Asian currency crises of 1997-98 or the European sovereign-debt crisis of 2010-2012. Disintegration of the eurozone could follow.
The other view – often dubbed the ballast theory – claims that the eurozone would actually be strengthened by Greece’s withdrawal. The monetary union would be rid of a recurring problem, and a eurozone decision to allow or invite Greece to leave would bolster the credibility of its rules. No country, it is claimed, could dare to blackmail its partners anymore.
Back in 2012, the domino theory looked realistic enough that the creditor countries ditched the Grexit option. Having reflected and pondered over the summer, German Chancellor Angela Merkel went to Athens and expressed her “hopes and wishes” that Greece remains in.
But the situation today is different. Market tension has eased considerably; Ireland and Portugal are not under assistance programmes anymore; the eurozone financial system has been strengthened by the decision to move to a banking union; and crisis-management instruments are in place. A Grexit-induced chain reaction would be significantly less likely.
But it does not follow that the loss would be harmless. There are three reasons why Grexit could still seriously weaken Europe’s monetary union.
First and foremost, a Greek exit would disprove the tacit assumption that participation in the euro is irrevocable. True, history teaches that no commitment is irrevocable: according to Jens Nordvig of Nomura Securities, there have been 67 currency-union breakups since the beginning of the nineteenth century. Any exit from the eurozone would increase the perceived probability that other countries may, sooner or later, follow suit.
Second, an exit would vindicate those who do consider the euro merely a beefed-up fixed-exchange-rate arrangement, not a true currency. Confidence in the US dollar relies on the fact that there is no difference between a dollar held in a bank in Boston and one held in San Francisco. But since the 2010-2012 crisis, this is not entirely true of the euro anymore. Financial fragmentation has receded but not disappeared, meaning that a loan to a company in Austria does not carry exactly the same interest rate as a loan to the same company on the other side of the Italian border. Critics like the German economist HansWerner Sinn have made a specialty of tracking exposure to the break-up risk.
None of this is currently lethal, owing to the initiatives taken in recent years; but it would be a mistake to assume that full confidence has been restored. European citizens would certainly respond to a country’s withdrawal (or expulsion) from the eurozone by starting to look at the currency in a different way. Where a euro is held would become a relevant question. Domestic and foreign investors would scrutinise more closely whether an asset’s value would be affected by a breakup of the monetary union. Governments would become more suspicious of the risks to which their partners potentially expose them. Indeed, suspicion would become irreversible, and it would replace the belief in the irreversibility of the eurozone.
Finally, an exit would force European policymakers to formalise their so-far unwritten and even unspecified rules for divorce. Beyond broad principles of international law – for example, that what matters for deciding an asset’s post-divorce currency denomination are the law governing the underlying contract and the corresponding jurisdiction – there are no agreed rules for deciding how conversion into a new currency would be carried out. A Grexit would force these rules to be defined, therefore making it clear what a euro is worth, depending on where it is held, by whom, and in what form. Indeed this would not only make the break-up risk more imaginable; it would also make it much more concrete.
None of this means that eurozone members should be ready to pay whatever cost is needed to keep Greece inside the eurozone. This would obviously amount to a surrender. But they should not harbour any illusions, either: there can be no such thing as a happy Grexit.