The euro might survive. But a cooperative Greek government, a real European programme to support Greek economic growth and a resolution of the Greek public debt overhang are minimal conditions for the short term. The euro's deeper flaws should also be addressed soon if a disorderly and destructive dissolution of the euro area is to be avoided.
The Greek people will vote on 17 June 2012 – or might not if the announced strike by Greek municipal employees wrecks the parliamentary elections. Post-election, three main scenarios could emerge: 1. Government led by the centre-right New Democracy – the party regarded as “pro-bail-out” with a wish to renegotiate the conditions; 2. Government led by the Coalition of the Radical Left (Syriza) – an “anti-bail-out” formation, but with the intention to keep Greece in the euro area; and 3. No government.
The no-government option would likely lead to political chaos and make the Greek exit from the euro a real possibility. A Syriza government would be a dark horse – the many measures they wish to reverse would be clearly unacceptable for the European lenders and the IMF, so either their campaign promises or their wish to stay inside the euro could remain unfulfilled. A New Democracy-led government might be able renegotiate the conditions of the bail-out programme and keep Greece inside the euro, at least for some time. But that wouldn’t be enough. The situation in the country is getting worse and worse and Europe must offer a prospect for Greece after the elections if a cooperative government is elected.
Commentators, especially from North America, take it for granted that Greece will exit the euro area and will be followed by others. As Peter Boone and Simon Johnson lucidly explained recently, “it is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers. … With IMF leaders, EC officials, and financial journalists floating the idea of a "Greek exit" from the euro, who can now invest in or sign long-term contracts in Greece? Greece's economy can only get worse.”
They are right in the diagnosis and also right in concluding that after a Greek exit the Germans and the European Central Bank would be reluctant to see a massive rise in ECB lending to other struggling southern euro-area countries. Europe is not prepared for an eventual Greek exit: the lending programme for Spain that is needed anyway could be put together, but an accelerated capital flight out of several southern euro-area countries cannot really be stopped. That could lead to a disorderly and destructive dissolution of the euro area, unless the United States of Euro is introduced immediately, which does not seem politically feasible.
But is a Greek exit really inevitable? There are very strong economic and political reasons for not letting this happen. Greek output would collapse massively and unemployment would skyrocket. The best way to prevent the acceleration of capital flight from other struggling euro-area members is to demonstrate the euro area's integrity. And the euro is not just about economics but has major historical and political roots.
In the short term much will depend on the results of the Greek elections. It is up to the Greek municipal employees to cancel the strike and up to the Greek people to decide the ‘Irish way’. Irish people voted yes for the fiscal compact on 31 May 2012 not because the fiscal compact will solve Ireland’s problems; it won’t. But Irish voters realised that a yes vote is a quid pro quo for many other issues. In fact, Greek choices now are pretty much the same as they were last November when former Prime Minister George Papandreou called for a referendum.
But even if the new government, irrespective of which party leads it, is able to agree with its creditors on amending the current programme somewhat, thus abating the short-term risk of a Greek exit and rallying markets, it still will not be enough. The very poor performance of the Greek economy must be reversed.
If we look at the export performance of EU15 countries since 2008, Spain is the best, followed by Germany, Ireland and Portugal – they outperform even the UK and Sweden, the only two EU15 countries which benefitted from sizeable nominal exchange rate depreciations. Therefore, even if the unemployment situation is miserable in Spain, Ireland and Portugal, their export sectors show signs of hope. But Greek exports look hopeless. The badly needed structural reforms will help, but not in the short term. In addition, the goal of reducing Greek public debt to about 120 percent of GDP by 2020 is not appropriate.
Consequently, euro-area partners should recognise two major issues and act on them decisively if a cooperative government is elected in Greece:
1. Greece’s economic outlook is hopeless. A real programme for supporting Greek growth should be put together with very significant investment from Europe. One of the two obvious instruments, better use of the structural and cohesion funds, should be employed but has limitations. But the other, European Investment Bank (EIB) investment, could be implemented disproportionally in Greece if the EIB's shareholders decide that way. Other instruments could also be envisioned.
2. Greece’s public debt is still too high. The Greek fortune cannot be turned to good without properly addressing the public debt overhang. Greeks were irresponsible in accumulating such a huge debt, but it was a major mistake of official lenders to start the first programme in 2010 without a sizeable debt reduction. Even in summer 2011 they insisted that no debt reduction is needed. As a consequence, they ‘socialised’ Greek public debt, but because of this, further significant public debt reduction cannot be accomplished without a kind of official sector involvement.
So Greeks should vote first. If a cooperative government is elected, but Europe fails to offer a prospect for Greece, the country will likely subsequently fall back to its current state. Then the scenario of Greek exit and the disorderly and destructive dissolution of the euro area could follow, unless all of the flaws in the euro's design are corrected promptly, which does not seem to be realistic.