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Tuesday, May 22, 2012

Grexit: Hard Choices and Inevitable Tradeoffs

Last time, we talked about why a Greek exit has become more likely and how policymakers are preparing for it. However, whether to exit or not won’t be an easy decision. A Grexit entails costs and risks, or else it’d have occurred a year ago. In this post, well discuss these costs and risks, first for Greece and then for other euro members. 

The Costs for Greece

Given that recent polls show about 80% of Greeks want to stay in the eurozone, it seems they’re aware of the costs, which are listed below.

(1) An exit destroys Greek savings. A Grexit means euro deposits in Greece will have to be redenominated in Greece’s new currency. Given Greeces high trade deficits and weak public finances, its new currency will be worth a lot less than the euro (with some estimates of a 60% depreciation). Such a depreciation will incur a huge loss for the Greeks.

(2) Contracts will have to be redenominated under the new exchange rate, which will result in a chaotic transition. Under a large, sudden depreciation, the cost of inventories and the loan burden to external creditors will shoot up. Many business will face bankruptcies.

(3) Though devaluation can restore competitiveness in the long run, rapid inflation makes lives difficult in the short run. Nevertheless, some commentators argue the economic contraction after default and devaluation, though severe, won’t last long. They often point to Iceland as an example. The country, which suffered from a credit crisis and a collapse of the financial sector back in 2008, is now on a steady path of recovery.

(4) Anticipation of an exit causes an outflow of Greek deposits to foreign countries. To protect their savings, Greek depositors prefer to save in a German bank (where savings will still be denominated in euro with purchasing power intact) rather than to save domestically (where savings will be redenominated and depreciate by a great deal). This is why Greeces deposits have fallen from $236 billion last December to $214 billion now. If the situation continues, banks will collapse and Greeces financial system will be wrecked.
The Costs for the Rest of Eurozone
A Greek exit will be tough for other euro members as well because of the following reasons.

(1) It may cause bank runs in other peripheral economies. Worried that their countries will ultimately follow the same path of Greece, Spaniards and Italians may take deposits out of domestic banks and put them in foreign banks. Again, this will severely damage the banking system of the respective countries, making the breakup of the euro area more likely.
(2) The risk of contagion is a serious threat to the European economy. Since many European banks have exposure to Greek debt, Greeces default and exit may spark a confidence crisis and cause a credit crunch. Though European finance ministers are working hard to build a firewall to deter the spread of contagion, and European banks have been offloading Greek assets in the past few months, these efforts may not be enough. The slump in stock markets around the world in the past two weeks suggests businesses and investors arent that confident in the effectiveness of the firewall.

(3) Grexit means the eurozone wasted lots of money to bail out Greece. In the last two months alone, the eurozone lent $140 billion to Greece in its bailout efforts. European leaders may not want to give up right after such large-scale bailout efforts, especially when Grexit means the rescue loans wont be paid back. However, one can argue that its time to stop the bailout and cut loss before its too late.

(P.S. Interestingly, some have proposed a conspiracy theory on why Germany doesn’t want Greece to exit. The fear is Greece’s exit will turn out to be a success and help the country return to growth. Observing Greece’s successful experiment, Spain, Portugal, and other distressed countries will want to follow suit and exit the euro. This will lead to the collapse of the euro.) 

Time to Make Hard Choices 

Given these costs, whether Greece stays in or leaves the euro isn’t an easy decision. However, after months of procrastination, Europe is finally at the critical stage where it must face inevitable tradeoffs and make hard choices. And a Greek exit is definitely an option to consider.

To me, Grexit is the only way out for Europe, because there is no way economies as diverse as Germany and Greece can stay in the same monetary union for long. It simply isnt sustainable. Greece cant restore competitiveness and will die a slow economic death if it remains in the euro. Other euro members cant prop up Greece and its financial sector forever, especially when Greece most likely wont be able to afford to pay back its loans. A Grexit is necessary despite its short-term pain, and what is important is to have an orderly exit and contain contagion to other countries.

(Entry 2 of 4 in the Update on the Euro Debt Crisis series) 

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