What If Greece Leaves the Euro?

Greece has done it again. In every previous stage of Europe’s crisis, Athens has had to go back to other members of the currency union, admit budget shortfalls, and ask for more financial help. The pattern has repeated itself once more. Greece’s still-new prime minister Antonis Samaras had to ask for more funds recently, even as he has had to beg for more time to meet agreed budgetary targets. But there is one key difference this time.
Many, particularly in Germany but also elsewhere in the euro zone, seem to have reached the limits of their patience. For the first time, officials have begun to speak openly about expelling Greece from the currency union. After more than two years of constant crisis, such responses are understandable. But the consequences of such a break might well carry more pain and expense than would further accommodations and compromises, so expulsion may be less likely than the rhetoric might indicate.
If Greece were the only problem, things would be simpler. Europe would have banished it from the euro months ago. Its economy, after all, is less than 2 percent of Europe’s gross domestic product, and its outstanding government debt amounts to less than 1 percent of all European bank assets.
The problem for Europe is that Greece’s fate hints at the fate of all the countries in Europe’s beleaguered periphery. Even with Greece securely in the union, the Continent faces the profound risk that a contagion of fear could bring down the finances of Portugal, Spain, Italy and others. Should Greece be pushed out, the probability of such a panic would rise significantly.

The roots of such fear are pretty plain. With expulsions, investors and bankers see forcible conversions of existing euro deposits into the newly revived national currencies. Since such new currencies would almost surely depreciate, they also see troubling losses on the real value of their assets. They expect expelled governments to repudiate their euro debts and anticipate that counterparties in those troubled economies will have difficulties meeting their obligations. Such prospects would prompt them, on the least hint of expulsion, to remove their deposits and assets to safer locations.
The whole pattern, by drying financial liquidity and driving up interest rates to all borrowers in such questionable countries, would compound their financial difficulties, deepen their economic troubles and so, in the self-fulfilling prophecy so familiar in finance, significantly raise the probability that they will in fact have to depart the currency union.
Even now, with only talk of a Greek departure, financial markets have begun to show such strains. Of course, Spanish bonds have sold well recently, and their yields have dropped enough to offer Madrid some relief. But that improvement stems entirely from comments made late in July by European Central Bank (ECB) president Mario Draghi that the ECB would buy large volumes of Spanish debt if necessary.
Otherwise, concerns for the future of the euro have driven funds away from Europe’s troubled periphery into Germany and other stronger economies—so thoroughly, in fact, that German interest rates have at times fallen below zero. The fears have curtailed cross-border interbank transactions, bringing them in June, the most recent month for which data are available, to their lowest level since the financial crisis of 2008. Several European banks have severed ties to their own subsidiaries in periphery countries. Germany’s Commerzbank and Deutsche Bank have ordered their Spanish and Italian branches to borrow from the ECB lending rather than rely on funds from headquarters. The European oil giant Shell has stated bluntly that it hesitates to invest funds in Europe in any way.
Should such fears spread, as they almost certainly would after a Greek expulsion, Europe could expect to face economic and financial pains comparable to those suffered in the United States during the subprime crisis of 2008–2009. Though fear of currency depreciation was not a factor in the American experience, default was a concern, as were anxieties about the abilities of counterparties to meet their obligations.
In the United States, the reluctance of financial institutions to advance credit in such an uncertain environment, even to each other, caused interbank lending rates to soar, despite the Federal Reserve’s commitment to keep its benchmark federal-funds rate near zero. The ensuing loss of liquidity widened credit spreads and forced asset prices to fall faster and farther than they otherwise would have, deepening and prolonging the recession. To a great extent, the lingering effects of this pain have contributed to the disappointing pace of recovery during the last three years.
Building Confidence in the Euro
If Europe, already in recession, wants to avoid a fate similar to that of the United States, then it must convince investors and banks that the euro is not in such jeopardy. Finding a way to keep Greece in the currency union is the easiest way to offer such reassurance, which, no doubt, is why Germany, France and others have worked to so hard to support Greece during these last two-plus years of crisis.
If Greece were to leave, the authorities conceivably could still quell the dangerous panic, but according to European officials, the effort would require three very difficult elements: 1) an enlargement of European Stability Mechanism (ESM) sufficient to convince investors and banks that it could bail out even large economies such as Spain and Italy; 2) a commitment by the ECB to make massive purchases of sovereign bonds; and 3) the introduction of general euro-zone debt, the so-called euro bonds.
The difficulties of mounting such an effort are well-known. Germany’s constitutional court may yet decide that the country cannot support the existing ESM. Even if the fund passes constitutional muster, there are questions about how Europe could raise the additional funds required. Member nations have no room in their budgets to give more.
The ECB has shown resistance to a popular proposal in which the stability mechanism would buy distressed sovereign debt and use it as collateral to borrow from the ECB in order to buy more sovereign debt. Neither is it apparent that the ECB would be willing to buy sovereign debt as actively as many seem to believe the situation would demand. Draghi has said that the central bank would do “what was necessary,” but he, and others at the ECB, also have shown a reluctance to get involved. Any wavering over how much is enough would inflame rather than dampen investor fears. Meanwhile, Germany has made clear that euro bonds are out of the question until Europe manages a fiscal union—something that, even in the best of circumstances, would take much too long to have any use should a Greek departure precipitate immediate panic.
This array of problems helps explain why the euro zone’s members have worked so hard to keep Greece in the currency union, despite all its past failures and broken promises. It also explains why Europe, even now, likely will compromise with Greece’s needs rather than end the relationship. To be sure, Berlin will try to get the best deal it can. It will continue to insist on safeguards, and it will demand that Athens correct its budget problems and retool its economy on a tight schedule, at least given the enormity of the task.
But for all the tough talk in Germany, Austria, Finland, the Netherlands and even Estonia, another compromise and more Greek promises seem more probable than an expulsion. Athens may go its own way. Politics, never wholly rational, may yet force the euro zone into draconian, if self-destructive, action. But if the politicians pause for even the most cursory review of costs and benefits, an expulsion of Greece looks less likely than compromise.