What happens if Greece leaves the Eurozone?
May 31, 2012
Recent elections in Greece and France have revealed significant resistance to austerity measures in the European Union, casting uncertainty over global markets.
We spoke with Jonathan Lemco, a principal and senior sovereign debt analyst in the Vanguard Taxable Credit Research Group, and Peter Westaway, Vanguard's lead economist in Europe, for their insights on the impact of Greece's potential departure from the Eurozone (and possibly even the EU itself), the complex political forces at play, and the possible implications for investors.
Is there a real possibility that Greece will leave the euro?
Peter Westaway: If you had asked me a few months ago, I'd have said absolutely not. Now I'd still say, on balance, that I think not, but the chance is much higher. The costs would be so enormous that policymakers in the EU will move heaven and earth to keep Greece in the EMU (Economic and Monetary Union).
If Greece could leave without causing serious contagion, then its departure could actually have advantages. But it would be very painful for Greece to do so unilaterally—for instance, if they elected a government that turned its back on the Eurozone. In that case, Greece wouldn't be able to pay its bills—it couldn't pay its civil servants or its pensions.
It's not even clear that Greece could even leave the euro area unilaterally. It's not inconceivable, for instance, that the EU could continue to give Greece money for a while or achieve some sort of compromise whereby Greece didn't enact all of the austerity measures they'd initially agreed to but would somehow stay in the euro area.
Jonathan Lemco: Greece's departure from the EU used to be unthinkable, certainly from an investor's point of view. A change has occurred recently—central bankers and finance ministers are now speaking openly about contingency plans. I believe the possibility of Greece leaving the EU within the next 12 months may be quite high.
The next thing to watch for is the coming round of Greek elections on June 17. They're being viewed as a referendum on the current debt package and on Greece's membership in the Eurozone. Right now, I'd say the elections are too close to call—they could go either way.
If Greece leaves the Eurozone, what would the impact be on the United States?
Jonathan Lemco: From a trade perspective, the impact would be modest. The impact on banking relationships would be more significant. But the largest impact would be the increase in investor skepticism. This "risk off" environment would see investors running for the safety of Treasuries or even gold.
Peter Westaway: I agree that from a market perspective, it would be really big. The whole purpose of a European monetary union versus an exchange-rate regime is that it is irreversible. People don't currently make investment decisions with an eye toward countries departing. If Greece leaves, these assumptions will be much less sound. Greece is small, but its exit would likely impact interest rates on bonds, creating possible currency risk and yield differentials. Even if countries like Portugal and Ireland quiet the initial speculation about their possible departure, there would be ongoing uncertainty about their enduring membership, and investors would likely price that into interest rates, leading to higher costs for those countries.
If Greece departs, will it signal the end of the euro?
Jonathan Lemco: I don't think it will be the end of the euro. The rich EU nations will do everything possible to ensure that the rest of the euro area stays intact—or the political, social, and economic implications will be enormous. But the main priority, if Greece leaves, will be creating a firewall to stop Portugal and especially Spain from following.
Peter Westaway: The euro could survive if Greece, Portugal, or Ireland left. The same is not true for Italy, the euro area's third-largest economy, or Spain, its fourth-largest. If either of these countries left, the whole thing would quickly unravel—the union would just be France, Germany, the Netherlands, and not much else.
What's at the root of the issue? Are Greece and the EU having second thoughts about this marriage?
Peter Westaway: Greece shouldn't have been in the euro area in the first place. If it had conducted an economic assessment of the pros and cons, it would almost certainly not have joined. I was at the Bank of England during the creation of the euro, and we did a five economic tests assessment to see whether the United Kingdom should join the euro area. But the U.K. was unusual—most other countries made a political assessment.
Countries like Greece have enjoyed benefits from membership in the monetary union—they gained a central bank in the European Central Bank, which could be trusted to follow a responsible monetary policy. But losing independence over monetary policy means that individual countries lose control of their own interest rates and exchange rate, thus removing an important mechanism for adjustment and putting more onus on the need for flexible wages and prices. And membership also came with obligations related to fiscal policy that Greece wasn't quite ready to meet.
If Greece does vote to depart the euro, will Germany be forced to soften its stance toward Spain and Portugal?
Jonathan Lemco: Yes, if Greece leaves the euro, Germany would likely agree to gentler debt-relief terms for Spain and Portugal. But the entire scenario would be easier, because these countries are in less trouble than Greece to begin with. Although Germany is saying no to concessions at the moment, other wealthy EU countries are urging more leniency. I think it will be important to see more cooperation between Germany and France as well as the rest of the EU.
Peter Westaway: If Greece were to leave as a result of the June 17 elections, the political response to Greece leaving would be geared toward making certain these countries don't come under pressure to leave the euro. The EU's politicians would be under increased pressure to step up, with limited forms of eurobonds or something like them, or euro-area-wide bank deposit guarantees to provide containment for the whole system. But as yet, these support mechanisms have not been built.
I believe such support would be forthcoming if Germany and the other members of the Eurozone were to feel it were absolutely necessary to keep the euro intact. It is important to remember that, in German opinion polls, we see that euro area membership is actually very popular. There's a deep-seated commitment in Germany to Europe. Even so, this commitment has been taken to the very limits by Greece. And if the Germans and other members of the monetary union don't see Greece making an effort, they really may be ready to cut it loose.
Any final thoughts?
Jonathan Lemco: Right now, German Chancellor Angela Merkel doesn't have the domestic political capital to make concessions, so she's stuck to a fairly rigid stance, demanding that Greece meet the conditions of its existing agreement before it receives more funds. I agree that Germany may yet grant more concessions, though.
Peter Westaway: It really may take Greece leaving before Germany will seriously consider conceding on eurobonds. Even then, Germany may only agree to such bonds under circumstances in which all euro area countries are playing by the rules and not running up debts. And it might be five to ten years before all countries meet those standards and Germany feels sufficiently confident to agree to these joint bonds. But by then it may be too late—we may be reading about the euro in the history books.