It is difficult to predict the fallout of the results of the recent Greek referendum. Greece has not voted for a “Grexit”. It has voted to reject a compromise with its international creditors. This is likely to be interpreted as wilful default by its biggest creditors, namely the International Monetary Fund, the European Central Bank and the larger eurozone sovereigns, Germany, France, Italy and Spain.
European leaders will suffer collateral political damage from a Greek default. By denying debt restructuring and further assistance to Greece, they are attempting to shut the stables after the horses have bolted. They will be seen to be complicit in the earlier bailout of reckless private creditors and banks without forcing haircuts. This process transferred liabilities to eurozone taxpayers, who will now be forced to take haircuts, even though they are stoutly opposed to a “transfer union”. This is because, at current growth rates, Greece has little option but to default on its external liabilities. German Chancellor Angela Merkel, the most influential European leader, recognises this. She is willing to consider debt restructuring, provided this leads to an effective fiscal and banking union. That would correct the fatal birth defect in the design of the eurozone that has held it hostage to financial markets.
Such a union would impose hard budgetary constraints on constituent states, the flip side of fiscal transfers, and curtail sovereignty far beyond existing Maastricht Treaty arrangements (which created the European Union). The eurozone would then resemble the American and Indian federations. Proposals to rectify these birth defects are on the drawing board, but leaders are resistant to them.
There is no better time than a crisis to take difficult political decisions. The Greek crisis presents a huge opportunity to bring long-term stability to the eurozone. Still, my best guess is that despite the IMF default and referendum, the can will be kicked down the road to buy yet more time. This will only be possible if Germany looks the other way while the ECB continues to backstop Greek banks. But the eurozone will continue to skate on thin ice until the bigger issue is resolved.
The underlying problem is a pattern seen often in developing countries: fiscal weaknesses and over-consumption in peripheral European countries, leading to widening current account deficits and eventual market revolt, hurting the ability to continue financing the deficits. The crisis in each country had different roots, such as fiscal overstretch (Greece), a real estate bubble (Spain) and private debt (Ireland), but they all ended up as fiscal problems because banks had to be bailed out. With pan-European operations, European banks have balance sheets much larger relative to their governments. Unlike in the US, the problem lay not so much in financial institutions too big to be allowed to fail, but with sovereigns too small to bail out large banks. This is why several countries needed external assistance from the stronger EU members, the IMF and the ECB.
Greece’s debt is denominated in its domestic currency, but has features akin to external debt. Greece does not have the monetary autonomy to print its way out of default, or to depreciate its currency to match its productivity. Only the ECB can print the euro. In such a situation, fiscal transfers are required to avoid default. And wages need to be adjusted through nominal, rather than inflationary, adjustments to restore competitiveness so external deficits can be reduced. This is politically difficult.
If the ECB withdraws support to Greek banks, Greece will have no option but to exit the eurozone in a disorderly manner. This would mean a great deal of frontloaded pain for the Greek population. Pension payments and healthcare services will be disrupted, economic activity will be hit on account of dislocations in the banking payments system and Greece might be in for a bout of hyperinflation.
A Grexit would, however, also give Greece the fiscal, monetary and exchange-rate flexibility to kickstart a recovery. During the euro crisis a few years ago, affected countries within the EU but outside the monetary union (the eurozone), such as Iceland, recovered much faster. Default and Grexit will do short-term reputational damage, but markets have a short memory. Defaulters have been known to regain access once fundamentals improve. Greece needs macroeconomic discipline to recover, whether it stays within the eurozone or exits it. By agreeing to a fiscal union, it can at least negotiate staggering the pain.
Will the No result in the Greek referendum lead to another international financial crisis? Ironically, despite all the post-crisis attention on financial institutions too big to be allowed to fail, neither the global financial crisis nor the eurozone crisis emanated from too-big-to-fail entities. The US subprime housing market was a relatively small segment of the very deep US financial markets. Greece is less than 0.5 per cent of the global economy. The danger lies in contagion.
In the case of the global financial crisis, opaque and complex structured financial products distributed through shadow banks made it impossible or difficult to determine on whose balance sheets the defaults would show up. This led to generalised risk aversion in financial markets and a credit freeze. In the case of Greece, it is clear that the risks sit on the balance sheets of strong sovereigns, the ECB and the IMF. Markets are unlikely to test them. But there are several weak, slow-growing eurozone economies with high levels of sovereign debt that can be serviced only so long as interest rates remain low. Greece’s public debt is around 175 per cent of GDP. But average European levels are as high as 100 per cent, above the threshold that has in the past had a negative impact on growth and macroeconomic stability. The threshold for the external debt of developing countries is even lower, at 60 per cent. Markets may be tempted to test them.
A Minsky moment (a sudden major collapse of asset values) can see borrowing costs increase, making existing levels of debt look increasingly unsustainable. Any contagion from the Greek crisis can snowball to expose Italy and even France. But the ECB can prevent this by acting on its “whatever it takes” pledge to maintain financial stability in the eurozone by stepping up its quantitative easing programme and buying bonds of weaker eurozone countries.
The writer is a civil servant. Views are personal