The realities of a Greek euro exit

THE chaos in Greece has resumed and a new election that nobody expects to resolve anything looms.

Exasperated EU officials have begun openly discussing the country’s exit from the euro. This is a grave mistake. Greece’s exit would be no less catastrophic than when the EU called it unthinkable — and not just for Greece.

“Divorce is never smooth,” Luc Coene, the governor of Belgium’s central bank and a member of the European Central Bank’s governing council, told the Financial Times on May 13. “I guess an amicable divorce — if that was ever needed — would be possible but I would still regret it.”

Amicable? That’s one thing Greece’s exit from the euro couldn’t be. As the economist Barry Eichengreen, the leading authority on these matters, has argued, it would provoke “the mother of all financial crises.”

The contemplation of this possibility by EU leaders is making matters even worse. Greece has no chance of recovery while this danger hangs over its economy.

Departing a currency zone under pressure is not the same as being forced off a currency peg — which, though painful, can be better than the alternative. Contracts would have to be redenominated and euro bank-notes would have to be over-stamped before a new currency could be printed and circulated.

That takes time, and since a huge devaluation is part of the formula, rigorous capital controls would have to be imposed on a country fully integrated into the wider EU economy. Bankruptcies would cascade through the system and the Greek economy, at least for a time, would shut down.

Devaluation would restore competitiveness — but to what end? Greece has a small export sector reliant on tourism. The other side of a devaluation — and a necessary condition for its success — is higher import prices and hence lower real wages. But resistance to the latter is why Greece is rejecting “austerity” to begin with.

Once Greece has its own currency again, it can resist falling living standards by printing money. That would neutralise the gain in competitiveness and lead, in the worst case, to hyperinflation. Advocates of an exit are saying, in effect, that if Greece were well-governed, it could avoid that outcome. It could:

lClear its debts through comprehensive default (as opposed to the partial default it has already tried);

lRestart its banking system from scratch;

lEliminate its primary budget deficit through orderly spending cuts and tax increases;

lSubmit to lower real wages;

lEventually restore its economy to health.

But if Greece were well-governed, we wouldn’t be having this conversation. You might therefore say, tough luck on Greece. Let it collapse and see what happens. That would be a salutary experience for the Greeks, and would teach others not to go the same way. The problem is that the effects of political and economic breakdown in Greece would spread much further.

Coene and other officials have been saying that Europe’s financial defences could withstand Greece’s exit and full default. It has been true all along that Greece is small enough to pose no systemic threat in its own right to the wider EU economy. That’s why the EU’s decision to allow this crisis to persist and worsen is such an amazing case of incompetence and irresponsibility.

The threat to Europe was never Greece, but Europe’s mismanagement of Greece. The big problem, getting bigger all the time, is the failure to deal with that small problem. There are two main channels of contagion from a Greek exit. One runs through Greek debts to foreigners.

This is probably manageable, even though the EU’s assurances about the soundness of its banks and the adequacy of its preparations are, on the evidence to date, grounds for panic rather than confidence. Certainly the EU’s wider financial system has had time to prepare.

The real danger, is through the second channel. If Greece can exit the euro, why not Portugal? Why not Spain? Why not Italy? Why not Europe? Even if the consequences of a Greek exit are as horrendous as I’m saying, those outcomes will no longer be “unthinkable”. The breakup of the entire eurozone will become a choice, however unattractive, rather than something that just can’t happen.

This means, among other things, faster capital flight from distressed peripheral countries to the core — compounding their difficulties and making their exit that much more likely. Investors have already started discussing how much smaller the euro system might need to be.

Here we come to the great irony in all this. The EU will surely strive to prevent the breakup of the wider euro system. Its leaders know that if the euro falls apart, the unravelling of the EU — again unthinkable, until now — becomes distinctly possible. So far, the EU’s political momentum has always pushed it toward closer union.

A splintering of the euro system would be the first time the EU had responded to a crisis by undoing earlier commitments rather than building on them. That’s a bad habit to get into.

So Greece’s exit from the eurozone would demand countervailing assurances that the rot stops there. The crucial innovations that Germany and its allies in austerity have resisted so far — jointly guaranteed euro bonds, and the ECB as a lender of last resort for distressed sovereign borrowers — would have to be adopted.

The measures that would have stopped things ever getting this bad would finally have to be taken up.

Greece’s ruin will have been for nothing, except to serve as an example to others. Likewise the distress in Spain and other peripheral countries. Steps toward full fiscal union will have been taken not because Europe’s citizens want them, not as a measured response to the crisis, but far too late, out of desperation after everything else had failed, with a correspondingly increased risk of failure. The EU will have shown that it cracks under pressure, which won’t be forgotten. And this is assuming all goes well.

* Clive Crook is a Bloomberg View columnist.