Is the German elite miscalculating the fallout from Grexit?

When the discussion in Berlin turns to a possible Grexit these days, the reaction is seldom more than a shrug. While most of those close to the ministries and the Berlin policy circles put the odds for a Greek exit from the euro-area now at around 40 to 50 percent, the drop-out of the small member states has all but lost its capacity to frighten. Officials and government politicians seem to believe that with the European Stability Mechanism (ESM) in place, negative yields on German bonds thanks to the European Central Bank’s quantitative easing and the ECB’s announcement of possible bond purchases of crisis countries under the OMT programme, any violent capital outflows from other periphery countries such as Portugal or Spain could be quickly mitigated with the existing instruments.

Privately, some officials even state that a Grexit could be a good thing.

Privately, some officials even state that a Grexit could be a good thing. First, it would teach other euro-area countries and their electorates a lesson. If Greece is forced out of the euro-area, its economy will spiral into an ever deeper crisis and a hyperinflation; no one in their right mind would again toy with leaving the euro, and voters from Spain to Italy to France would refrain from voting for populists questioning austerity packages or even euro-membership. According to this narrative, a blow to Greece under Syriza’s rule would also be a blow to Podemos in Spain, to the Front National in France and to Sinn Fein in Ireland.

Moreover, one could even seize the moment to push through further integration of the euro-area. If markets turn against some weaker member states after a Grexit, there might be less resistance among the rest to cede further sovereignty over budgetary questions to Brussels.

It is far from clear that a Grexit would turn into the projected catastrophe over the medium term.

While this storyline seems to gain followers by the day, some of the underlying assumptions are highly questionable on a closer look. Let me focus on the economics of a Greek exit from the euro-area: it is far from clear that a Grexit would turn into the projected catastrophe over the medium term. In fact, there is a historical precedent which proves that even chaotic defaults and devaluations do not need to turn into deep and prolonged depressions. In the early 2000s, Argentina tried desperately for some time to service its debt and to implement IMF-imposed austerity programmes. Finally, after years of recession and huge increases in unemployment, in early 2002 the country defaulted and exited its currency board (an exchange rate arrangement which had pegged the peso at parity to the US dollar and under which the Argentinian economy was heavily dollarized). International investors were furious and the Economist predicted the country would spiral into hyperinflation and permanent crisis.

The opposite happened: even though it took a while to sort out the insolvent banking sector, already in the quarter following the default and depreciation, the Argentinian economy showed the first signs of recovery. By the middle of the year, it had embarked on a new growth process. Inflation rose, but prices levelled off after a while. The predicted hyperinflation never came. If we compare Argentina to Greece, we see that the Argentinian crisis was much shorter and less severe than what Greece has so far experienced under the troika programmes (see graph).

Of course, all this was not a smooth ride. The peso depreciated by 75 percent. The savings of the Argentinian middle class were wiped out and poverty initially increased further because of rising import prices. But over the years following the depreciation, unemployment fell sharply, poverty was reduced and per-capita incomes in Argentina rose more quickly than in neighbouring Brazil. (For Argentina, this recovery did not prove stable in the long run, as populist governments later put policies in place which eroded all the gains made through the depreciation.)

There are a number of parallels between Greece and Argentina in their pre-crisis macroeconomic situation.

Greece might not be Argentina. Argentina benefited from a commodity price boom in the years after its depreciation. But there are a number of parallels in their pre-crisis macroeconomic situation. And if we see that Argentina managed to pull off a (relatively) successful default and exit from a fixed currency, the argument that Greece can never do it because of its weak institutions suddenly seems much less convincing.

However, if Greece’s exit from the euro-area turns out to be less than a complete catastrophe, the German elite’s calculation might badly backfire: What do you think will happen to the euro-sceptic populists in the rest of the euro-area if the Greek economy recovers within a year after a Grexit? And if such a euro-area exit no longer inspires fear among periphery countries, how can one convince financial markets that a Grexit was for Greece and for Greece only?

In the end, it is one thing to be convinced that you have a world-class airbag and passenger protection in your car, and another to remain in that car in a crash test.