The Longer-term Consequences of Greece Exiting the Euro Would Be Expensive and Divisive

There is a debate right now between those who argue that the single currency can more easily survive a Greek exit from the euro than it could have in the past and those who argue that it will be a shock to the markets similar to the collapse of Lehman Brothers in September 2008. That debate will only end if the crisis abates or there is a natural experiment. The differences between the two camps are irreconcilable.

There is less discussion of what would be the longer-term impact of Greece exiting the euro. Optimists argue that the euro will emerge as a more disciplined union because member states will know that they will not be bailed out. Pessimists warn that Europe will stagger from crisis to crisis as market participants turn on weaker member states as soon as the first sign of trouble. This seems to be a stark dichotomy and yet it is not.

What both sides are saying is that markets will start to price national assets differently across the monetary union and depending upon how well each country is governed. Hence the longer-term consequence of Greece exiting the euro is a return of geographic risk to European financial markets. The question is how much that geographic risk will cost in terms of economic performance and stability.

There are three reasons to believe that the cost will be high. The first reason has to do with economic performance. Any difference in bond prices across countries will also affect the price of capital for non-financial enterprises. This means that Italian, Spanish and Portuguese firms will pay more to raise capital and to pay for new investments than their German, Dutch and Austrian counterparts. It also means that larger firms in peripheral markets will have an added cost advantage over small and medium sized enterprises. As a result, the peripheral countries will grow more slowly and benefit from less innovation than they would otherwise. This will drag down European growth prospects over all.

A second reason has to do with economic stability. The introduction of geographic risk premiums will interfere with the transmission mechanism for European monetary policy. This is the problem that European Central Bank President Mario Draghi warned about at the height of the Italian and Spanish crisis in July 2012 and it is the reason he launched the program for Outright Monetary Transactions the following September. The problem is that changes in monetary policy instruments in Frankfurt have less impact on monetary conditions in the periphery when markets price in geographic risk. Peripheral economies will experience greater macroeconomic volatility as a consequence. Moreover, national fiscal policy will not expand to compensate. On the contrary, the market incentives will be for national fiscal policy to act pro-cyclically by tightening when tax revenues contract and expenditures increase which is what happens during an economic downturn. Such macroeconomic volatility will create another structural difference between those countries that are privileged and those that are punished by the markets.

A third reason to believe that the cost of reintroducing geographic risk premiums will be high has to do with the efficiency of market infrastructures. Here we should look at the European Union’s real-time gross payment system (Target 2, or T2) and its new arrangement for cross-border settlement in securities (T2S). Greece is a full member of Target 2 and one of four founding members of T2S. Should Greece exit from the euro, European leaders will need to figure out how to unwind Greek positions in both arrangements. We do not have to know how that unwinding will take place to imagine that it will be a shock to the two connected systems. The result will be a change in how peripheral countries access central bank money for payment and settlement. The current systems are built for speed and efficiency; any future arrangement will sacrifice some of those advantages in favour of geographic risk management. Once again the peripheral countries will be disadvantaged.

The longer term impact of Greece exiting from the euro will be the creation of a two-tiered (or multi-tiered) Europe – with one tier suffering permanent disadvantages in terms of the cost of capital, the volatility of macroeconomic performance, and the efficiency of market infrastructures. Moreover, this future is consistent with the predictions of both the optimists and the pessimists. Whatever the short-term impact of Greece leaving the euro, there will be expensive and divisive long-term consequences.


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