More on the political economy of the coming Grexit

In February I wrote about the political economy of a Greek default (and euro zone exit), predicting that a Grexit was all but inevitable. In the last few days, there has been an almost feverish debate about this issue, so I wanted to update you with my thinking given how the situation in Greece and the eurozone has deteriorated since February.

Let me start with the draft post I wrote on the issue slated to go up on US News and World Report later today. Here’s what I wrote in response to the question, “Should Greece leave the European Union?” posited by US News:

The question many macro analysts are asking today is whether Greece will leave the euro zone. As Greece’s situation is untenable economically and politically, a Greek exit from the euro zone is likely. A brief review of the situation demonstrates why.

With a quarter of the population unemployed and fully half of Greece’s youth without work, Greece is clearly in an economic depression that can only worsen as government budget and wage cuts suck money out of the Greek economy. The depression has radicalized the voting population, pushing the Greek people to their breaking point; many voters have defected from the two mainstream Greek parties which they hold responsible for the depression and have flocked to more extreme fringe parties. These parties have rejected the crushing austerity programs carried out by Greece’s two mainstream parties.

Meanwhile, in Germany, voters are concerned about rewarding Greece’s so-called fiscal profligacy with German taxpayer money. Germany, with a government debt burden now in excess of eighty percent of GDP, has long been in violation of the European government debt hurdle of sixty percent debt to GDP itself. German voters are fearful that despite the wage sacrifices of the last decade, they could end up paying to reduce their own government debt burden and the Greek government burden at the same time. Because the perception in Germany is that Greece’s problem is of its own making, German voters will not reward domestic political parties that advocate aiding Greece without very onerous bailout conditions attached.

But since the Greek economy is on the verge of collapse, German voters demanding more pain means there is little hope in the economic and political situation in Europe for Greece continuing in the euro zone. The political situation in Greece mandates non-compliance with the existing austerity regimen, which will result in EU and IMF assistance being withheld. Greece will have no choice but to default and exit the euro zone.  However, once Greece reverts to the drachma, after the extreme economic chaos that results, Greece will benefit from a substantially weaker currency that is the missing link in allowing the country to pull out of its debt deflationary spiral. Will Greece exit the euro zone? The answer is resoundingly yes.

This question is quite different than the question of whether Greece should leave the euro zone or the even more difficult question of whether leaving the euro zone automatically means that Greece must also leave the European Union. Those are political questions that are unanswerable. My sense is that European policy makers are committed to both maintaining the integrity of the euro zone and of the European Union; Europe’s leaders are therefore willing to much more to prevent the euro zone or the European Union from breaking apart. But there is only so much they can do; given the constraints, I believe the euro zone will break apart despite best efforts to prevent this. But there are no economic reasons that the European Union itself must also break apart.

Now, the editors told me they are still debating whether to ask the question about the euro zone alone or the European Union as a whole. [Update: they now want to roll with the question addressing just the euro zone and not the EU.] But it is a relevant distinction given what we heard in November during the Italian crisis. See "If Greece left the euro zone, it would have to leave the EU". At the time, I said "I am sure that they could figure out a way to get Greece out of the euro zone without it’s having to exit the EU. But, the official line has to be tough lest periphery governments start to get ideas." And I still believe this is the case. Exiting the euro area is not synonymous with leaving the European Union.

Now that we have that out of the way, let’s look at this thing holistically. Let’s work backwards from the end results.

• Greece will either leave unilaterally or by mutual consent or it will be kicked out.
• Greece’s departure will be the result of the economic situation in Greece, contagion to the periphery or to the core. Or Greece’s exit could be a political decision based on playing to the views of domestic constituents in euro area countries.

If Greece were to leave unilaterally, it would be a departure that resulted from Greek domestic economic and political forces. In my view, we are nowhere near this point. Alexis Tsipras, the leader of the leading anti-austerity party Syriza, has said point blank that he does not want Greece to leave the euro zone. His call is simply to stop the crushing austerity. Moreover, poll after poll in Greece shows that people in the country still want the euro. To me that says the goal for Greek voters now is in improving their economy within the euro zone and the only way to do so in voters’ minds is to roll back austerity. So, were Greece to end up exiting the euro zone either unilaterally or by mutual consent, we would need to see the population move to an anti-euro stance. In my view, this can only happen if Greek politicians continue austerity and the economy continues to worsen further still. How long will it take before Greeks throw in the towel? It’s hard to say. Latvians went through this escapade in order to qualify for the euro and GDP contracted by almost 25%. In Greece, GDP is down under 15% at present, with a projection for another 6% baked in. Judging from Latvia then, it is clear that we could see a lot more downside before the Greeks throw in the towel. And remember, the political parties aren’t even talking about an exit yet.

On the other hand, were the Greeks forced out of the euro area, it would likely be as a result of non-compliance with euro zone mandates. Euro governments are supposed to maintain fiscal discipline. The goal is to "ensure closer coordination of economic policies and sustained convergence of the economic performances of the Member States”. That is not happening. Moreover, Greek politicians are talking openly about ignoring all of this and unilaterally deviating from the agreed to austerity upon which further Troika aid is conditioned. Given the political resistance to more bailouts in places like Germany, the Netherlands, Finland, and Slovakia, I anticipate that a unilateral move by Greece would end all further aid to Greece from the Troika and Greek banks by the ECB, prompting default and/or a banking crisis. If Greece’s position within the euro zone after a re-default is seen as untenable, given the situation in the banking sector, the unilateral move could potentially then mean an exit from the euro zone. See How and why Greece will leave the euro zone.

Again, I have to stress here that three things have to occur first:

• You have to get Greek politicians voting to renege on their austerity pledges.
• Then you have to see this move met by a cut off of aid from the EU.
• Then you have to see the resulting default lead to a movement within the EU to exclude Greece from the euro zone altogether.

Thinking these steps through in reverse, I still think the bar is very high here.

• It is not clear that the Greek politicians which are anti-austerity will form part of the next government. Nor is it clear that they could actually act upon their anti-austerity pledge when faced with a cut off of funds. remember that Hungary played chicken with the Troika and faced a similar cut off. The country promptly backpedalled and is now trying to hammer out terms with the Troika. 
• Moreover, Greece currently runs a primary budget deficit of around 5% of GDP. Were it to default and exit the euro zone, Athens would be forced to immediately cut government expenditures until the primary fiscal budget becomes balanced. A lot of public sector employees would be sacked, pensions would be at risk, and unemployment would go higher.
• The euro zone countries would have to be willing to allow losses from Greek sovereign debt and losses from the resulting corporate bankruptcies to crystallise on balance sheets. This would mean the potential for bank runs, a massive bailout of euro area banks and unknowable levels of contagion to sovereign, banks and corporates. If Greece defaulted within the euro zone, however, the recapitalisation of the banks would be manageable without the bank run and contagion.
• Germany in particular would have to be willing politically to say "we caused the euro zone to break apart". Given how wedded to the European Project the Germans have proved to be. This would be an extraordinary admission.

Bottom line: These steps can only be taken at the end of a long and miserable economic and political downward spiral when all other options have failed. So, while I do think Greece will eventually exit the euro zone, I still do not think it can happen immediately unless the economic and political situation deteriorate much further.

What does this mean in the interim? For me, it means that we will see more bailouts and credit writedowns of Greek debt. Likely we will see a Greek re-default that prompts or is presaged by a euro zone bank recapitalisation. But, we also will likely see more austerity that means greater unemployment and lower GDP in Greece until the political situation prompts a re-evaluation or until the primary deficit is closed.

Market plays: avoid Greek sovereign debt, avoid Greek bank equity and debt, avoid Greek corporates.

I will leave it at that until we have examined Spain and Italy and the rest of the periphery.