Original Publication in German (press here): Katsikas, D., (2013), “Sollte Griechenland in der Eurozone bleiben – und falls ja, warum?”, Bundeszentrale für Politische Bildung, 06 November.

Should Greece remain in the Eurozone and, if so, why?

Dimitris Katsikas

Head, Crisis Observatory, Hellenic Foundation for European and Foreign Policy (ELIAMEP)

Almost from the beginning of the Greek crisis in late 2009, there have been calls for Greece to leave the Eurozone –the so-called Grexit. These calls were usually intensified by adverse economic and political developments in Greece, such as the withdrawal of the Troika mission during the autumn of 2011, following the unwillingness of the Greek government to follow through the stipulations of the agreed adjustment programme, or the domestic political crisis triggered by the former prime minister’s proposal for a referendum on Greece’s stay in the Eurozone in late 2011. The proponents of Grexit can be found in a wide array of analysts, political parties and market participants, both within Greece and abroad. Leaving market players engaged in speculative bets against Greece and other self-serving agents aside, we can classify Grexit proponents into two major “camps”: those who think that Greece’s problems are too big for the Eurozone to tackle, that is, the bill is too big for the other Eurozone countries to pay; and those who believe that the programme that is being implemented is detrimental for Greece; the country would be better off leaving the Eurozone, breaking thus free from the shackles of an extremely harsh conditionality programme, which has caused economic and social devastation.

Let us first examine the latter point. Would Greece be better off out of the Eurozone? The proponents of this proposal employ a typical economic argument; outside the Eurozone Greece could have its own currency, which would be devalued, allowing Greece to restore its international competitiveness and gradually return to growth. High growth rates would help make the debt sustainable, while the anticipated increase in tax revenues would help Greece achieve a primary surplus. Is that the case?

When discussing economic policy, one should always take into account the specific characteristics of the country in question. Exports make up a small part of the Greek economy. In 2008, before the crisis had struck, exports of goods and services accounted for 24% of GDP. This was much lower than the European average (42% for the Eurozone and approximately 41% for the European Union). It should also be noted that this poor performance would be even worse without the contribution of services (particularly tourism-related). Exports of traded goods in 2008 were approximately 9% of GDP; in 2012, following three years of two-digit increases in exports and at the same time, continuous decline of GDP, exports of traded goods still only accounted for 13.5% of GDP. Given the small contribution of exports to the Greek GDP, the potential impact of a devaluation of a Greek currency on the growth potential of the country will be much lower than what is anticipated by the proponents of Grexit. Indeed, this positive impact would probably be even smaller, given that many of the goods that Greece exports are dependent for their production on imported intermediate products and production equipment. A devaluation of a Greek currency would increase the price of these inputs thereby canceling part of its benefit on price competitiveness.

On the other hand, exit and devaluation would have certain, not-so-negligible, negative economic effects. First, one should keep in mind that a devaluation would increase dramatically the prices of imported goods, which still dominate the Greek market. This would translate in an instantaneous impoverishment of the Greek population, which would be unable to purchase even basic goods. This development would come after three years of income reductions and profit deterioration for Greek employees and entrepreneurs respectively and while a large part of the population (currently estimated at 27%) finds itself in unemployment. The collapse of consumption that would ensue would most likely wipe out a large part of the Greek GDP, which has already been reduced by approximately 22% since the beginning of the crisis, leading to a further increase in unemployment. It is not hard to imagine the social unrest that would follow in such a situation. At the same time, the currency devaluation would increase the burden of the public debt manifold (given that the debt would still be denominated in euros). To become sustainable, a dramatic haircut would have to be implemented. Such an action, beyond the extremely negative consequences for Greece’s relations with its European partners (who, following last year’s Greek debt restructuring and second bailout loan, now hold most of Greece’s public debt), would also deprive Greece of any possibility of tapping the financial markets. In these circumstances, the government would most likely resort to printing money. However, unless the government would be willing to risk an inflation spiral, such a policy would need to be strictly circumscribed. This in turn would mean that most of the austerity measures adopted thus far would have to be retained, given that Greece has still not achieved a primary surplus.

These problems would become even more serious if we take into account the political consequences of a potential Grexit. A decision to exit Eurozone would most likely be accompanied by a call for elections, since any government would need to have a popular mandate to proceed with such a dramatic course of action. Given the current distribution of electoral power and the extremely negative and polarized political climate prevailing in Greece at the moment (certain to become even more polarized following a Grexit decision) elections are unlikely to produce a clear winner with a governing majority. Unfortunately, as it has already become clear, coalition governments do not work very well in Greece. The tripartite government formed last year after two rounds of elections, lasted only one year and the new two-party government has an extremely thin majority of five in parliament. In conditions of social unrest, political polarization and conflict are bound to rise with unpredictable consequences.

The volatile social and political climate, the loss of the monetary policy credibility of the ECB, the absence of a credible and constraining policy framework (such as the Eurozone economic policy framework) and following its unilateral debt restructuring, the alienation of Greece from both its European partners and the markets, would leave the country weak and isolated. In such circumstances, it is highly unlikely that Greece will be able to proceed with the deep and wide-ranging structural reforms that it needs. The remedy to Greece’s low competitiveness and ultimately its declining economy is the reform of its inward looking, consumption-based growth model. This will not be remedied through exit and devaluation. The overhaul of Greece’s growth model is a process that will take many years to accomplish and should be based on deep structural reforms in the Greek economy and state. Enhancing productivity should be one of the priorities of such reforms; currency devaluation may provide a temporary boost in price competitiveness, however it cannot substitute for the long-term, productivity enhancing structural reforms that the Greek economy needs. Unless such reforms are implemented, the most probable long-term outcome following exit from the Eurozone, would be a series of devaluations and an permanently high level of inflation, a situation which Greece experienced during the 1980s.

What about the claim that the cost of bailing out Greece is too much for the Eurozone to handle? A Grexit, accompanied by unilateral default on part of its debt would have an adverse effect on the public finances of all the European countries that have lent it money. This would come at a time when the European economy is once again in recession and most European governments are trying to bring down their fiscal deficits and public debt, which had reached record levels in the aftermath of the 2007-09 financial crisis. However, the adverse fiscal effects because of the Greek default would not be the most significant problem. The real problem would be the spread of the crisis to other countries. After three years of experiencing this crisis, it is hardly necessary to make the case for the risk of contagion resulting from Grexit. Time and again we have seen how negative developments in one country lead to turbulence in the financial markets across Europe and often the entire world. Once Greece failed to follow through its adjustment programme and exited the Eurozone, confidence in the ability of other countries to overcome their problems would collapse. It is not only the magnitude of the problems of the countries in the periphery that would undermine the credibility of their efforts. A Grexit would also convince the financial markets of what they have been suspecting all along, given the haphazard, ambivalent and weak response of the Eurozone to the crisis thus far: European leaders are not ready to do whatever it takes to save the Eurozone.

Sovereign interest rates would soar; Portugal and Ireland whose programmes are near completion would not be able to access the markets and they would need new bailout loans. Spain and Italy would present an ever greater problem. The inability of these countries to borrow from the markets could bring about the breakdown of Eurozone itself. The funds needed to bailout these countries are far more than what is currently available at the Eurozone stability mechanisms. In the absence of Eurobonds or a common budget large enough to accommodate their funding needs, these countries would be led to either default on part of their debt, or leave the Eurozone to print money. Either event would send shock waves to the financial markets, which would raise interest rates across the board, plunging Europe and probably the rest of the global economy as well, in a new recession.

In other words, the real question is not whether the Greek bailout is too much for the Eurozone to handle. Greece is a member of a monetary union that has proven itself fragile and unprepared for such a crisis; if the bailout of Greece fails, the cost will be high, not only for Greece but also for the Eurozone itself. The real question therefore is whether the Eurozone will pay the price for bailing out Greece, even if this is relatively high, or whether it is willing to risk a Grexit, whose cost could be immeasurably higher. Having said that, this is just a probable scenario; it is not certain that it will come to pass. However, its consequences are so devastating that we should not be contemplating Grexit as an acceptable option, even if the outcome is uncertain.

In conclusion, I believe that Greece should remain in the Eurozone. A Grexit holds very little, if any, economic benefits for Greece; on the contrary, it has the potential to bring about a severe economic, social and political crisis. Moreover, Greece would not be the only one to suffer. A Grexit could spark a new European and global economic crisis with potentially devastating effects for other countries that could bring about even the breakdown of the Eurozone itself.