The times they are a changin

A reprieve, nothing more

by The Economist

CITI economists Willem Buiter and Ebrahim Rahbari write:

First, we raise our estimate of the likelihood of Greek exit from the eurozone (or ‘Grexit’) to 50% over the next 18 months from earlier estimates of ours which put it at 25-30%. Second, we argue that the implications of Grexit for the rest of the EA and the world would be negative, but moderate, as exit fear contagion would likely be contained by policy action, notably from the ECB.

Not "Grout"? Exposure to Greece among European financial institutions was always relatively small given the relatively small size of the country. Banks have been working furiously to reduce even that, and with the European Central Bank now directing a flood of money toward euro-area banks it looks, to these fellows at least, as if the economic and financial risks of a Greek departure are mostly contained. As this paper acknowledged recently, the cost of a Greek exit to the broader euro zone is falling:

For the rest of Europe, a Greek exit would also be dangerous: it could cause bank runs, capital flight and soaring bond yields in Portugal, Italy and beyond. But over time the balance of risks will change. Once a tough debt restructuring has been imposed on Greece’s private creditors, the country’s fate will have less impact on other bond markets. As reforms in Italy and Spain gain momentum, the distinctions between Greece and others will become clearer. And over the coming months European leaders, with luck, will agree on a permanent way to boost their rescue funds. All this would make the spectre of a Greek exit much less frightening for the rest of the euro zone.

For Greece, on the other hand, departure is unlikely to work out well. A devaluation would make Greek exports more competitive, but in the short term the chaos of a departure would likely reduce or eliminate entirely the benefit of a cheaper currency to Greece's top export industry—tourism. The new Greek currency would likely overshoot on the way down, and given the country's fiscal difficulties rapid inflation, and perhaps hyperinflation, would loom as a threat. In all likelihood, Greek money and labour would flee the country in droves, potentially forcing the country to adopt tight capital and border controls. The country might well wind up a failed state, a political and economic wreck.

Perhaps euro-zone leaders are counting on this shifting leverage—a much worse outcome to exit for Greece than for the single currency—to help them drive a hard bargain. It is no sure thing, however. There is a serious risk that officials are overstating the extent of Greek containment; in the days before Lehman's bankruptcy, according to reporting at the time, the heads of Goldman Sachs and JP Morgan were said to believe that having seen the bank's troubles coming from so far away, Wall Street should be well prepared to handle the death of the firm. One question looms particularly large: would a Greek exit convince markets that Greece is a special case or would it raise the perceived odds of exit of all other euro-zone members?

I am surprised at how likely an exit now looks. I continue to hope that the euro zone finds a way to avoid it, however. Unintended consequences can be nasty things.