The two most crucial questions about the Greek public debt crisis have been whether the country would be forced to default on its public debt and whether it would have to leave the euro area.
At present Greece has pursued an orderly default on its privately held debt, but it remains in the euro area. Default and departure are thus not necessarily connected. I have argued elsewhere that Greece needs to default also on its official debt to reduce its total public debt to a sustainable level. But here I argue that it must not leave the euro area because the result would incur immense harm to Greece, other countries in the European Union, and to the world at large. It would not be merely a devaluation for Greece but a serious, possibly mortal, disruption of the European Monetary Union (EMU). John Normand and Arindam Sandilya of JP Morgan issued a paper in December 2011, concluding that the damage would be enormous. This comment agrees with that analysis, but tries to take it further.1
The EMU would not be the first multi-country currency zone to break up. Europe has seen at least five breakups of such monetary unions in the last century, but they have been completely different in nature. Two breakups occurred under the gold standard and with separate central banks and payment systems, and they were benign. The Latin Monetary Union, first with France, Belgium, Italy, and Switzerland, and later including Spain, Greece, Romania, Bulgaria, Serbia, and Venezuela, lasted from 1865 to 1927. It failed because of misaligned exchange rates, the abandonment of the gold standard and the debasement by some central banks of the currency. The similar Scandinavian Monetary Union among Sweden, Denmark, and Norway existed from 1873 until 1914. It was easily dissolved when Sweden abandoned the gold standard. The outstanding feature of these currency unions was that fixed exchange rates were guaranteed by the gold standard, and that central banks and thus payment systems remained separate.
The three other examples of breakups were of the Habsburg Empire, the Soviet Union, and Yugoslavia. They all ended in major disasters, with hyperinflation in several countries and massive falls in output of up to 50 percent in some. Yugoslavia and five post-Soviet countries faced wars. These dissolutions were prolonged, and the longer they lasted, the worse the economic disaster became. The cause of the breakups was political disagreements, as the old center of the union and most successor states trying to maintain the currency union after it had proved impossible to do so. Their centralized payments systems were paralyzed, which inhibited payments and trade for long periods. The ultimate disaster came in the form of competing central banks issuing the same currency, which prompted hyperinflation.2
In important respects, the EMU is more reminiscent of these three malign cases than the two benign ones. The EMU lacks rules and procedures for its members to exit, and it has a centralized payments system, which is a true poison pill. There is no reason to believe that an exit would be easily accepted. The only advantage possessed by the EMU in comparison to the breakup of the other monetary unions is that the ECB would retain a firm monopoly on the issue of money.
For Greece, the only real advantage from an exit from the euro would be the possibility to devalue its new currency so that it could become competitive. Yet, without a Latvian-style internal devaluation, Greece would also forego many desirable structural reforms.3 An independent monetary policy would hardly be an advantage if Greece were to end up in a devaluation-inflation cycle, which is what one would expect. The negative effects, by contrast, would be massive, both for Greece and other countries. These effects would likely be magnified because international financial transactions are so much larger and faster than in the past.
As Normand and Sandilya point out: “In a modern financial market dominated by electronic payments and in a zone free of capital controls… the switch to an alternative currency would need to be secretive and practically immediate to be effective. Mere suspicion of a regime switch would be sufficient to drive massive deposit flight… Most likely a country would decree overnight that the country’s legal tender had changed from euros to the new currency at a declared conversion rate, and that all accounts and contracts would be redenominated immediately… All financial markets would be shut and banks closed for some period—perhaps several days—to allow the conversion.”4
There are ten major likely negative effects, if Greece exits the EMU and re-introduces the drachma.
1. The EMU payments system would collapse because it is centralized to the ECB. To re-establish a payments system is both politically and technically difficult. Jeffrey Sachs and David Lipton elaborated on what was needed to restore the Russian payments system after communism,5 and it took three years to do so. Even after the Russian financial crash of August 1998, the Russian payments system broke down for three months. Most payments had to be made in cash dollars.
2. Given that the payments system is likely to collapse, and the value of bank money is uncertain, anybody who can would try to take out cash from the Greek banks. A massive bank run would be assured, and all banks would likely collapse. The Greek government would then have no choice but to close the banks for a prolonged bank holiday. The bank system would stop functioning.
3. Anybody who was able would transfer money abroad in connection with Greece’s exit from EMU. The government would have no choice but to impose strict currency controls (which are prohibited in Article 63 of the EU Lisbon Treaty). Capital controls would conserve some currency, but would also block most trade and transactions for months.
4. Traditionally, new banknotes are circulated after a currency reform. They can be of three kinds: stamped old banknotes (done in Czechoslovakia after World War I and again in the Czech Republic and Slovakia in 1993); new provisional banknotes (in most post-Soviet states in 1992 and 1993); or real banknotes, the ideal and eventual solution. New reliable banknotes cannot be printed for at least three months for technical reasons, and such a step cannot be taken in advance of a currency reform because the information would leak and cause devastating capital outflows. Thus Greece cannot have any banknotes for a few months, while the bank and payments system are not working. Presumably, the Greeks would hang on to their cash euros and smuggle in cash euros from abroad. It would be very difficult to re-establish any credibility of a drachma. The euro banknotes are designed by one letter for each country, Y for Greece. But these markings have no practical significance because the banknotes circulate throughout the euro area without any particular concentration to any country, just as US banknotes formally pertain to one of the regional Federal Reserve Banks.
5. The Lisbon Treaty contains no provision for exit from the EMU. Nor is there an international forum for sovereign arbitration on financial issues. This legal vacuum would have to be filled in accordance with political agreements between Greece and the other European Union and euro countries. But such negotiations would be prolonged—easily two years, to judge by the European Union’s slowness in responding to the crisis in the last two years. Meanwhile all legal issues would be hanging in the air. Contracts for hundreds of billions of euros would presumably remain in dispute. Eventually the contracts might be tested in courts, but that would take time, spreading uncertainty over thousands of companies facing bankruptcy.
6. If the drachma is reintroduced in the midst of a severe financial crisis, its exchange rate is bound to fall like a stone, because Greek currency reserves are small. A vicious depreciation-inflation cycle would ensue. Excessive depreciation would bring high inflation, possibly in the triple digits, or even hyperinflation.
7. These conditions would cause a new default. If the value of the new currency falls by only 50 percent in relation to the euro, the best expected public debt to GDP ratio for Greece in 2020 would be 240 percent, which would force a write-down of three-quarters of the remaining public debt in the order of €200 billion.
8. All these conditions would devastate the Greek economy. Companies exposed to significant currency mismatches would be forced into bankruptcy. Output would collapse, easily by 30 percent over two to three years, about half of what we saw in the former Soviet Union. Unemployment would skyrocket and real euro wages would plummet to a fraction of their previous level.
9. These developments would strain any country, but Greece also suffers from substantial corruption and little trust in the political system. Its entire fragile political system would collapse.
10. The European Union is not likely to let Greece stay in the European Union itself if the country abandons the euro, so Greece would lose the many advantages it now enjoys, including a few percent of GDP in EU structural funds, agricultural subsidies, and other grants. Greece could also be excluded from the customs union and thus face trade discrimination; it would be excluded from the Schengen visa area, which would limit tourism.
For all these reasons no Greek government should even think of abandoning the euro. A necessary additional default for public and private creditors can and should be done within the euro area. To become competitive again, Greece should instead cut wages and public expenditures. Its public expenditures remained at 48 percent of GDP in 2011, which is far too high. Even in a worst-case scenario, Greece should not have to endure a GDP contraction of more than 10 percent on top of the 15 percent already incurred. Outside of the EMU, Greek GDP could contract two to three times that amount, threatening its very sustenance. I have abstained from speculating about military actions, but note that the Greek-Turkish war over Cyprus occurred as late as 1974.
Nor should the rest of the European Union think of kicking Greece out of the euro area as some top German politicians have threatened to do. Although the consequences for the rest of the European Union would not be as severe as for Greece, they would be entirely negative and truly formidable. The effects would proliferate throughout banks, bond markets, trade, public finance, and politics, hitting certain countries more severely than others. There are at least nine strong reasons why the European Union must not contemplate the exit of Greece from the EMU.
1. A Greek exit from the EMU would likely cause a new global liquidity freeze worse than the one that struck after the Lehman Brothers bankruptcy in 2008. First, the freeze would proliferate through the banking system. Hundreds of billions of euros of contracts would be in dispute, and nobody would trust banks anywhere. After the Lehman crisis, international liquidity froze for half a year. This crisis would be at least as severe, and it should bring down many of the already weak European banks, especially in southern Europe.
2. A second channel of proliferation would run through bond markets. With a new and much deeper Greek default, all vulnerable sovereign bonds, and perhaps all euro bond yields, would rise sharply. It would be difficult for Portugal to avoid default, which would cause further panic in bond markets.
3. A third channel of proliferation would be trade. A sharp drop in global trade would be likely, and it would be particularly strong around Greece and in the European Union.
4. As a consequence of these three factors—bank crisis, bond market crisis, and a trade slowdown—a deep European recession and rising unemployment (which is already10.7 percent of the labor force) would appear inevitable. EU GDP fell by 5 percent in 2009, and this drop could be worse since the origin of this crisis would lie in the European Union and many reserves have been exhausted.
5. With such an economic contraction, the public finance situation would deteriorate severely. Since the public debt of the euro area has already reached 89 percent of GDP, several countries would probably be vulnerable to default, further aggravating the situation. The countries with more than 100 percent of GDP in public debt—Portugal, Ireland, Italy, and Belgium—are the most obvious candidates, but most countries in the EMU could enter dangerous territory.
6. Specifically, Cyprus is not likely to be able to manage a Greek exit from the EMU without default and a series of bank collapses because of its close financial links with Greece and its tiny size with a population of only 800,000 souls.
7. A couple of European Union countries outside the EMU would probably enter renewed financial crisis, requiring new financial assistance from the IMF and European Union, notably Hungary (which is generally weak) and Romania (which is weak and exposed to Greek banks).
8. A banking collapse in Cyprus would also hit Russia and Ukraine, which have most of their international payments going through Cyprus because of very favorable double-taxation agreements from Soviet times. This could disrupt the supply of oil to Europe.
9. Politically, the European Union and the EMU are likely to function far worse in the face of the exit of Greece from the EMU, because the precedent of departure has then been set. Their very survival would be put into question. That such an European Union could handle these crisis issues is unlikely.
For the sake of both Greece and the rest of the European Union, the question of a Greek departure from the EMU must be taken off the EU agenda.
1. John Normand and Arindam Sandilya, “Answers to 10 Common Questions on EMU Breakup,” J.P. Morgan, December 7, 2011.
2. The literature on the collapses of these three currency unions is ample, notably, Leo Pasvolsky, Economic Nationalism of the Danubian States. London: George Allen & Unwin, 1928; Thomas J. Sargent, “The Ends of Four Big Inflations,” in, Rational Expectations and Inflation, Thomas J. Sargent, ed. New York: Harper and Row, 1986, pp. 40–109; Rudiger Dornbusch, “Monetary Problems of Post Communism: Lessons from the End of the Austro-Hungarian Empire,” Weltwirtschaftliches Archiv 128, no. 3: 391–424; Anders Åslund, How Russia Became a Market Economy. Washington: Brookings Institution, 1995; Brigitte Granville, “So Farewell Then Rouble Zone,” in Russian Economic Reform at Risk, Anders Åslund, ed. New York: St. Martin’s Press, 1995, pp. 65–88.
4. Normand and Sandilya, op. cit., p. 2.
5. Jeffrey D. Sachs and David A. Lipton, “Remaining Steps to a Market-based Monetary System,” in., Changing the Economic System in Russia, Anders Åslund, and Richard Layard, eds. New York: St. Martin’s Press, 1993, pp. 127–62.