Greek Exit? Very Unlikely.

The Governor of Malaysia’s central bank has said that a Greek exit from the Eurozone could precipitate a rolling crisis akin to the Asian crisis. She may be using an analogy rather than drawing a direct parallel, but I think that the similarities are limited. In the Asian crisis, capital inflows turned to capital outflows, country by country. In the Eurozone, the disappearance of private-sector funding for current-account deficits has already happened; the periphery is already dependent on fiscal (EFSF/ESM/IMF lending) and monetary (TARGET2) flows from the official sector to fund its deficit. The question at issue over Greece is whether fiscal flows will be stopped, and whether such a stoppage will inevitably mean the end of monetary flows as well.

I suppose there is something of a parallel inasmuch as the monetary flows only allow the continued financing of government deficits if banks in peripheral countries judge that their governments are solvent. Since euro exit is de facto insolvency, the possibility of euro exit might cause Spanish and Italian banks to fear for the solvency of their sovereigns, thus causing contagion in the bond markets. This is not guaranteed to happen, however.

Angela Merkel is already losing public support for her austerity-centred response to the crisis. If Greece were forced into economic collapse, her support would presumably weaken still further. This observation should give us pause before predicting with too much confidence that bailout funds would cease to flow if Greece refused to meet some of the terms of its bailout. The corrosive narrative of “virtuous” Germans bailing out “feckless” Greeks might have some traction in Germany, but Germans also believe in European solidarity and would no doubt be appalled at the spectacle of a collapse in the Greek economy. I think it is far from clear that the political situation will not move far enough to accommodate Syriza’s demands, should it become part of the Greek government after the next election. The current crisis might force Greece out of the euro; but it might equally be the final catalyst needed for Germany to move towards a more reasonable fiscal transfer mechanism.

Let us leave that aside, and assume that the EU is really prepared to cancel the bailout (or that Syriza is really likely to overplay its hand to the extent that the EU feels it has no choice). My analysis yesterday (“Leaving the Euro?”) highlights the steps that have to happen for Greece to be forced out of the euro. A crucial one is the ejection of the Bank of Greece from the Eurosystem. Would the Bank of Greece necessarily have to be ejected in the event of a government default? I do not see why, and indeed there is no mechanism to force it to happen gainst the will of Greece. If that is so, then Greece could (and, without an explicit decision to the contrary by a functioning government, would) remain in the euro. The banks could be recapitalised by the EFSF/ESM (following an agreement by EU countries to allow direct lending to banks). Euro exit is not inevitable, even if the government defaults. Given the (likely massive) short-run costs of euro exit, I cannot see any reasonable government choosing it.

Could Greece’s banks collapse in the event of a total government default? Absolutely, if European policymakers decide to let it happen. But such a decision would be out of line with their behaviour in the crisis so far, which has been to act to prevent collapse, whatever their previous statements. Let us assume the worst-case scenario of a total default by Greece on all of its government debt — which is what the latest fears are really about. The banks’ capital would be wiped out. In Iceland, when the banks collapsed, the government provided them with new equity and was able to protect depositors. In Greece, the government would be in no position to do this, but the ESM could, and I think it is likely that it would.

This takes me back to the view that I have held for some time: that it is highly unlikely that any country will decide to leave the euro.

If Greece defaulted on all of its debts, what effect would this have on the rest of Europe? The thing is, private-sector holders of Greece’s debt have already been pretty-much wiped out, and everybody knows that Greece’s debt is still completely unsustainable. I do not think a default would change very much. Spain and Italy should be able to continue to fund themselves for as long as their own banks consider them to be solvent — which they probably are — and as long as official sector capital inflows continue to fund their current-account deficits.


  • Capacity utilisation 79.2% b.e. Apr. New post-crisis high. US growth continues.
  • Industrial production 1.1% b.e. Apr. A very strong number.
  • Japan prelim GDP 1% MOM b.e. Q1. Boosted by temporary subsidies for fuel-efficient cars (presently scheduled to expire in August) and the start of Tohoku reconstruction.

Coming Up

  • Initial claims
  • Philly Fed manufacturing index