A Greek Tragedy

It would likely happen on a most unexpected day. One turns on CNN only to find Breaking News coverage from Athens; Greece has left the Eurozone. Greek Prime Minister Girogos Papandreou holds a solemn speech stating Greek banks will be shut for a week and when re-opened, depositors will find their accounts in Greek Drachma, no more Euros. He states that all other options have at this point been exhausted; his country has yet again failed to meet deficit targets which were a condition for further aid. Europe declares it will stick to the agreed terms. No more help. Greece is bankrupt. What now?  

                                                                                                                                   Source: CNN

A positive effect would be that the competitiveness of Greece would instantly receive a massive boost. This is both for trade in goods but also services such as tourism. Chief Economist Buiter of Citigroup expects the Drachma would devalue 40% against the Euro, while UBS economists estimate up to 60%. Simultaneously however, import prices would rise significantly which could lead to demands for higher wages. The pressure to reform would be lessened after not being subject to Europe’s demands so wages could rise and the government could print money to finance the country. This inflation would be damaging and scare international lenders and yet again cut off Greece from crucial access to capital markets.

Internally for Greece, the banking sector would face the biggest problem. The devaluation of the Drachma would strongly let the value of debt payable internationally in Euros increase. The government would immediately be bankrupt. Greek banks hold government bonds of about 45 Billion Euros, which amounts to 160% of their own capital. If the Greek government defaults, the nation’s banking system would have no support and be wiped out. No economy can survive without a functioning banking system so the banks would have to be bailed out. The government would have no money to do this and it becomes conceivable that Europe would provide a massive capital injection for Greece’s banks as they exit the Euro to make their way into a new monetary system. Internationally, Europe’s banks would certainly be impacted, France’s institutions alone would have to write off 16 Billion Euros. However, they would survive. A haircut of 80% would hit German banks for example with a capital reduction of just 2.4%.

From the point of view of other countries, some natural discipline would be imposed as incentives are set right. Spain, Ireland, Italy and Portugal would see that the rules of the Eurozone are to be adhered to and targets met or a member must leave. However, if speculation on these countries ignites putting them into a similar position Greece finds itself in today, the EFSF would by a large margin be too small to save them. It is estimated by Commerzbank that the fund would have to increase from a current 528 Billion Euro capacity to 1.2 Trillion Euro, a political impossibility. The ECB could intervene and purchase debt in an attempt to calm markets and provide a much needed source of stability for the Eurozone. However, if this too becomes too onerous, further countries would be forced to quit the Euro. The monetary union would shrink back to something it was once supposed to be, a zone of similar and stable countries.

A Greek default brings many inconveniencies and further hardship for the Greek people with advantages that seem negligible in the short-run. How many more Billion will be needed though, how much more evident must the disadvantages of a transfer union become before the all-members-inclusive-Eurozone reaches its breaking point? It should be kept in mind that a default does not mean end of Greece. The country has defaulted four times since its founding; in 1843, 1860, 1893 and 1931. Perhaps 2011 will be next.

Further Reading:
http://edition.cnn.com/2011/BUSINESS/06/19/europe.debt.explainer/index.html
http://www.ft.com/cms/s/0/d2d8b422-fb13-11e0-bebe-00144feab49a.html#axzz1bcrkHal2