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Sunday, May 20, 2012

A Potential Greek Exit from the Euro

This post, first in the series, will discuss the possibility of a Greek exit from the euro. Given the results of the Greek general election, an exit has become an increasingly likely outcome.
Greece’s Legislative Election 
Many Greeks are fed up with contractionary austerity measures imposed by eurozone leaders. Thats why, in the election on May 6, many voters turned to support the Coalition of the Radical Left (known as the Syriza party). The Syriza party, which opposes austerity, tells voters that Greece can stay in the euro even if they reject the bailout package. This strategy won the Syriza party a lot of support and a lot more seats compared to the last election. On the other hand, the PASOK, a pro-bailout party which was previously the largest party in the Parliament, suffered a heavy defeat

But the May election didnt produce a clear winner. After failed attempts to form a coalition government, Greece is heading to a second-round election on June 17. Polls show that pro-bailout parties is likely to lose the election again in June.
Potential Exit from the Euro

Following the election results, a Greek exit (or Grexit, as some now call) has become a lot more likely. If the anti-austerity parties win the second-round election and they reject the bailout package, Greece will probably be kicked out of the eurozone. Even if the Syriza party doesnt win and the election results in another stalemate, Greece wont be able to put together a coalition in time. The terms of the bailout package will surely be breached, and a Greek exit will still be likely.

Despite what the Syriza party says, talks of forgiving Greek debt are fantasy. The party is only making promises they cant deliver in order to win votes. Debt forgiveness will send a perverse message to Spain, Ireland and Portugal that the eurozone rewards defiance by writing off a countrys debt. To ensure these countries will comply with the austerity programs previously agreed upon, Germany and other euro members won’t allow the moral hazard of forgiving Greek debt.

But maybe an exit is in Greeces interest. A commentary on Der Spiegel, a German news magazine, persuasively argues that leaving the euro is the only effective way for Greece to regain competitiveness in the long term. The article points out that default can help reduce Greece’s debt burden, while devaluation can restore cost competitiveness and boost net exports. The eurozone benefits as well since it doesn’t need to spend more money on Greece’s bailout.

Preparation for the Grexit

Greece is a small economy (in terms of GDP) in the euro area. Grexit doesn’t have to be catastrophic as long as the aftermath doesn’t spread to bigger economies. The policymakers are starting to manage expectations and prepare financial markets for a potential Greek exit.

Christine Lagarde, Managing Director of the International Monetary Fund, told the press that the IMF must be “technically prepared for anything.” In the past few months, Europe’s economic and regulatory institutions have been building firewalls and recapitalizing banks. They hope this can prevent contagion to Spain and Italy if Greece exits the euro.

(Entry 1 of 4 in the Update on the Euro Debt Crisis series) 

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