The balance of financial terror

by Jean Pisani-Ferry on 22nd May 2012

The relationship between Greece and the rest of the euro area are increasingly reminiscent of the Cold War’s balance of terror. We are speaking of financial terror only and Greece is no USSR, but the mechanics are strikingly similar.

Start with the options for Athens. It is important to distinguish between budgetary and external aspects. Greece is forecasted to record a slight primary budget deficit in 2012, so should it default, forcing European partners to unplug assistance, it would have to tighten more (although only marginally). More importantly, the current account deficit is still expected to be close to 8 per cent of GDP this year. Without assistance and in the absence of significant private capital inflows, this deficit could only be financed by the ECB increasing its exposure even further. Should it refuse, as likely, Greece would be forced to close its external deficit precipitously – either within or outside the euro area.  If forced into an exit, what remains of the economy would instantaneously fall into chaos. Financial disruption would be massive, resulting in a chain of bankruptcies. Currency depreciation would substantially overshoot, especially as policy institutions have no credibility whatsoever. Foreign goods and equipment would become unaffordable. Eventually, but eventually only, depreciation would help rebuild competitiveness. In the meantime the damage would be massive. 

Turn now to the euro partners. A unilateral Greek default would undoubtedly be costly for them. Euro-area official exposure to Greece through assistance loans, ECB claims on the central bank and ECB holdings of government bonds amount to more than €250bn. To this sum must be added private sector exposure through bank loans and equity, roughly another €100bn. Additionally, a Greek exit would signal that there is nothing irrevocable with participation in the euro, turning the European currency into a sort of magnified fixed exchange-rates system; equally importantly, it would force to set rules for converting euro-denominated claims into the new currency, thereby indicating to every business or household what their assets and liabilities would become in the case of a euro break-up. No doubt this would trigger massive precautionary moves and undermine the rest of the euro area, starting with the weakest countries within it.

So each side can do major harm to the other one. The question is: will it happen?

Greek public opinion is adamantly in favour of remaining in the euro area while alleviating the austerity burden. But this is an inconsistent proposal. A Greek threat to default within the euro is not be credible if the ECB is ready to stop extending liquidity. The next government could wish to renegotiate some aspects of the programme or give priority to certain reforms. But it will still need a conditional assistance programme, until it completes the largest part of its adjustment.

The EU official line – no renegotiation of the programme, no exit at any price – is not credible either. First, it is hard to see how to object to changes in domestic priorities proposed by a newly elected government. For example, why should the EU rejects proposals to tax more and spend more, if this leaves the deficit unchanged?  Second and more importantly, the EU cannot deter Greece from making use of its leverage if the price it puts on exit is infinite. To strengthen its hand and make its tough line credible, it has to be ready to contemplate a forced exit. But the EU can only do that if equipping itself to limit potential damages. This means beefing-up firewalls and speeding-up preparations for further integration of the euro area through banking union and the issuance of common bonds. Here, it is Berlin that lacks consistency. Signals that it is close to reaching the limits to the price it is ready to pay to keep Greece within the euro are only credible if accompanied by willingness to consider bold moves to preserve the common currency. 

A lesson from the Cold War is that ultimately, rational behaviour proved to be the best insurance against disaster. Today also, both partners have a common interest in behaving in cool blood. They have to set red lines credibly and unambiguously, as well as to indicate where there is room for discussion. This can only happen after June 17, when a new coalition emerges from the election and forms a government in Athens. In the meantime, we are bound to live dangerously.


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