Two of the great risks facing the European Union (EU) economy are the exit of Greece from the euro area and the exit – or distancing – of the United Kingdom from the European Union. It is easy to think of these threats as similar, even if only because they have similarly catchy names to use in popular debate. But Kings College London Professor Anand Menon reminded me in a recent conference call that they are actually very different. His point was that any British exit from the European Union – or ‘Brexit’ – would be a long, difficult, and conflictive process. My argument here is that any Greek exit from the euro – or ‘Grexit’ – would centre on a short, punctuated event.
Menon’s argument is worth laying out in some detail because he has an important point to make both for British citizens and for other EU member states. The debate about British exit started in earnest when UK Prime Minister David Cameron promised to hold an in-or-out referendum during a speech on Europe he held on 23 January 2013. In that speech, Cameron committed the make the case in favour of Britain staying in Europe. He also admitted that Europe needed to be changed. That admission reflects the fact that many of his backbenchers dislike much of what the EU has to offer and many Conservative voters are attracted by the anti-EU message that is touted by the UK Independence Party (UKIP). The reason for offering a referendum was to lock in the support of disaffected Conservatives and wavering voters in the run-up to the May 2015 parliamentary elections.
There are three things to note about the way this is set up. First, the referendum takes place only if the Conservatives win. So far the Labour Party has resisted the urge to make a similar pledge about holding a referendum during the next Parliament should it lead the government. Second, neither Cameron nor his speech writers could predict what would happen if an in-or-out referendum were actually held. The polling numbers are all over the place. Depending upon how you ask the question, support for EU membership in the UK is either very low or very high. Moreover, referendum politics is a complicated business. This means that there is a real prospect that the outcome could go against the EU but a chance it could offer a surprising endorsement as well. Third, and most important, a vote to leave the EU would not result in a sudden end to the relationship. Instead it would lead to a complicated negotiation over how the UK could change is relationship with other EU member states, how it could extract itself from its many institutional obligations, and how it would deal as an independent nation with the outside world.
Long and complex negotiations create many different kinds of uncertainty – about financial commitments, property rights, trade relations, market access, and political influence. That is why a UK exit from the European Union would be such a shock to the EU economy as a whole. Firms and other market actors would have to slow down the pace of their activity until enough dust settled for them to be able to make plans for the future. The pace of deceleration would start slowly as different actors began to appreciate the implications of the referendum outcome and how they would affect specific economic interests. It would gather momentum as second- and third-order implications became more apparent. And it would drag down European economic performance so long as the conflict between the UK and its European partners continued. This is how a ‘process’ threat unfolds and it is worth appreciating because there are ways that policymakers can improve (or worsen) the process in terms of its economic impact. Of course, this assumes they cannot find some way to avoid the process altogether.
A Greek exit from the euro area would look very little like this British case. The fundamental reason is that very few people in Greece want to leave the euro. Hence the Greek government is likely to hold onto its position within the single currency for as long as possible, using every conceivable policy instrument to prevent having to embrace the alternative of creating a new and separate Greek currency. That is why it is more useful to think of a Greek exit as an event and not a process – it will happen when the Greek government has no more instruments to help it stay in the single currency or, what is more likely, when the cost of staying finally crosses the threshold of Greek tolerance and leaving the single currency becomes the only alternative. Of course, there will be negotiations and conflicts following a Greek exit and these will drag on for an unforeseeable amount of time. There is a process involved here as well. But the shock of exit will be more important than the process that follows in terms of its impact on European economic performance.
To see what I mean, it is useful to think of a plausible scenario. I wrote about this before in May 2012 when Greek had its last electoral crisis. It still strikes me as the biggest threat to Greek participation in the euro. This scenario pivots on the prospect that at some point the Governing Council of the European Central Bank (ECB) will not allow the Bank of Greece to extend further emergency liquidity assistance to key institutions in the Greek financial sector. That will force Greek central bankers – and, hence, the Greek government – to choose between staying the euro or saving the banks. That is a binary choice. If they choose to stay in the euro and wind up the banks, they will have to put capital controls on other financial institutions and watch as the Greek economy goes through another severe contraction. That is the route that Cyprus followed in March 2013. The Greeks might choose the alternative, which is to prop up the banks. If they do so, the Governing Council will have to define any liquidity created by the Bank of Greece as being uniquely Greek and so no longer denominated in official euro. In other words, whatever loans the Bank of Greece makes, and whatever they choose to call those loans, will no longer be part of the single currency. This event will create turmoil in the markets because it is hard to imagine the full scope of implications. Like the collapse of Lehman Brothers, it will create unknown unknowns.
Fortunately, Europe’s leaders seem to be walking back from the threat of a Greek exit. The Governing Council should decide at its meeting this week to restore the waiver on the use of Greek assets as collateral in routine euro area refinancing operations. That means that Greek banks will have less need of emergency liquidity assistance and so Greek central bankers and politicians will have less pressure to choose between their money and their banks. Unfortunately, however, that is not the end of the story and three sets of factors could spark trouble. The political dynamics surrounding the latest Greek agreement are only the most obvious source of threat. The institutional politics unfolding within the ECB Governing Council are also important. Finally, we have to worry about the health of the Greek banks. A sudden deterioration of the climate in any of these three areas could rapidly bring us back to the threshold where Greek politicians have to consider whether to take actions that will result in their country’s expulsion from the euro. Let’s hope that event never comes to pass.Follow @Erik_Jones_SAIS