In Germany, an alarming change in the mood of policy makers has taken place over the past weeks: while it is still accepted and publicly stated that it is worth fighting for the euro, there is a growing perception that it does not make sense to fight for the euro in its current form.
This feeling was first demonstrated when Chancellor Angela Merkel reacted to the former Greek prime minister George Papandreou’s plan of a referendum on the rescue package with the remark that Greece would have to leave the euro if it defaulted on its debt. It was further underlined when a paper from the finance ministry was leaked to Spiegel Online looking into the consequences of a Greek exit with a baseline scenario in which the (then smaller) euro zone would re-emerge stronger and more stable than before.
In the past days now, I have had encounters with several policymakers or their staff in Berlin and they were very relaxed about Greece leaving the euro. Most of them were arguing that a default was on the books anyway, that its consequences could be managed with the current EFSF institutions and that an exit would therefore not make much of a difference. Some did not even realise that a Greek default and an exit from the euro area are two distinct issues and that a default would be possible within and outside the euro-area.
This attitude is extremely dangerous. As my colleague Daniela Schwarzer from the German Institute for International and Security Affairs and I argue in a new German language publication, a Greek exit from the euro area will open up a new channel of contagion to the other euro-zone countries which might have the power to rip the whole currency union apart. This channel of contagion would come on top of contagion through the market of government bond yields which we have observed over the past 18 months or so.
The problem seems to be that many people are speculating about a Greek exit without looking at historical precedents. An important episode here is Argentina which left a currency board (an arrangement in which the currency was pegged one-to-one to the dollar and under which the Argentine economy was heavily dollarised) in the early 2000s. Argentina defaulted on its debt and devalued strongly in 2002, after several austerity packages had failed to restore market confidence (doesn’t that sound familiar?). The interesting point about the Argentine experience is that commentators predicted chaos and hyperinflation. Instead, the country embarked on a nice growth trajectory which started almost immediately after the devaluation and inflation remained in check. In inflation-adjusted terms, per-capita-GDP in Argentina from 1999 to the present day grew even more briskly than in Brazil (which is often perceived as the fabulous growth story of Latin America).
If Greece were to leave the euro area, its policy makers would most likely look at Argentina’s experience to minimise damage to their own economy. One important element of a Greek devaluation would thus almost certainly be a forced conversion of all bank deposits and loans into the new national currency as has been done in Argentina. Without such a step, any devaluation of the new currency would bankrupt the Greek corporate sector and the Greek banking sector, as liabilities would still be in euros, but incomes in a devalued new currency.
Thus, after an exit, any euro deposit in a Greek bank would only retain a fraction of its former value. This, of course, would be noticed by the depositors in Portugal, Spain and Italy. As it is very easy in the EU to open an account in another member state and transfer funds, the logical consequence will be a wave of capital flights from the banking system of the euro periphery into Germany.
This would be a completely new development. So far, capital flows from most banking systems (with the exceptions of Ireland and Greece) have been limited. The reason has been that the ECB has acted as a lender of last resort to the banking system in all euro countries, even if it has been reluctant to do so for governments.
Potentially, the outflows could be enormous. With the possibility to easily and cheaply transfer money between a German and an Italian bank account (and withdraw money from a German account at Italian ATMs), in principle there is no need for an Italian to keep any funds in the Italian banking sector. However, the Italian banking sector would never be able to withstand the outflow of several hundreds of billions of euro, as the funds are invested to a large extent in illiquid assets such as mortgages or corporate loans.
If such a capital flight were to take place, even the ECB’s tools would be limited: Under normal circumstances, the central bank lends to commercial banks against good collateral such as government bonds or investment-grade corporate bonds. As the Italian banking system does not have enough of these assets to cover for a full-blown bank-run, such operations would be limited. While the Bank of Italy still would have the instrument of emergency liquidity assistance at its disposal, this instrument has never been used in the euro area to an extent as would be necessary in such a situation and a number of uncertainties are connected to its use.
Alternatively, of course, one could reinstate capital controls and prohibit transfers out of Italy. As this would need to be supported by border controls in order to prevent the transfer of large amounts of cash to Austria or France, this would be a serious drawback for the idea of a common market.
If these instruments fail, a situation could develop in which Italian policy makers are faced with the choice whether to see their banking system implode or whether to follow Greece out of the euro with other countries such as Austria, France, Belgium and even the Netherlands following like dominos.
In short: be careful what you wish for. Even if you don’t care what happens to the Greek economy, an exit of Greece from the eurozone will most likely have catastrophic consequences for the rest of the currency union. Policy makers should take these dangers into account before playing with the Greek exit option.
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