Greek Euro Exit More Likely as Situation Spirals Out of Control

May 18, 2012 Updated: October 1, 2015
People line up outside a Greek bank
People line up outside a Greek bank as an employee drives away a young street musician in central Athens on May 2. The deposit flight since parliamentary elections on May 6 is as much as 700 million euros ($893 million), President Karolos Papoulias told party leaders on Monday. (Aris Messinis/AFP/GettyImages)

NEW YORK—Two years after Greece shocked financial markets for the first time in 2010, its political economy might finally have reached the event horizon as the country is facing a disorderly default and an exit from the eurozone.

The results could have far-reaching consequences, even for the United States.

Recent Election Results in Political Deadlock

Before the recent election on May 6, there was still hope that the two parties that work with the international institutions that provide assistance to Greece would form a majority government. After last Tuesday, however, it became clear that this would not be the case as the left-of-center PASOK and the right-of-center New Democracy parties fell just a couple of seats short of the majority needed.

Subsequently, talks about forming a government with parties on the extreme of the political spectrum and mostly against further austerity broke down.

The spending cuts imposed by international institutions such as the European Union (EU), the International Monetary Fund (IMF) and the European Central Bank (ECB)—the so-called “Troika”—in exchange for bailout funds are very unpopular with the Greek people, who vented their anger in the recent election.

Given that it is impossible to form a new government, elections will have to be repeated in June. Because of the dramatic situation in the country, anti-bailout parties are likely to gain more votes.

Non-Compliance with Bailout Rules Forces Hand of Troika

With nobody in Greece to take responsibility and wide areas of the civil service, including the Finance Ministry and the tax collection agency, in partial or complete shut-down, the officials from the Troika have nobody to talk to.

On the other hand, they risk losing face in front of the international community if Greece continues to violate the rules set forth in the “Memorandum” about spending cuts and debt reduction.

Signs that the Troika will start to take a tougher stance and risk a Greek exit from the euro came from the ECB yesterday. Mario Draghi, the president of the central bank, said in a press conference: “The Governing Council’s strong preference is that Greece will continue to stay in the euro area” but also added that “This is not a matter for the Governing Council to decide,” when asked about the eventuality of a Greek exit. Later on Wednesday, unidentified sources within the central bank leaked that the ECB will stop liquidity provisions to certain Greek banks, which lack sufficient capital and therefore violate the requirements needed to obtain financing directly through the ECB.

Stakes Are High for Both Parties

Given the fact that the whole of the Greek banking system depends on ECB funding, signs of a popular bank-run are emerging.

People were lining up to withdraw their money in front of banks across the country. The deposit flight since the election on May 6 was as high as 700 million euros($893 million) according to a speech given by President Karolos Papoulias to party leaders on Monday.

“There has been a pick up of deposit flight from Greece,” Charles Dallara, head of the International Institute of Finance (IIF) and chief negotiator in the latest debt restructuring, told reporters in Ireland. He expressed his hopes that the deposit flight could be contained after new elections, “Once you get a new government in place, if that government reaffirms its intention to remain in the eurozone.”

If the ECB with the tacit approval of the EU and the IMF will let Greece leave the eurozone, the costs to both parties will be huge. JPMorgan Chase estimates the cost to the official sector to be at least 400 billion euros ($508 billion), including official loans, exposure of the ECB, and losses of EU banks. This estimate does not include the fallout ranging from a chain reaction in derivatives to contagion spreading to Ireland, Portugal, Italy and Spain, as well as the massive loss of credibility and confidence that EU policy makers and especially the ECB will suffer.

Greece on the other hand would face a complete economic collapse, and without a government in place, the risk of social unrest cannot be underestimated.

Goldman Sachs analysts summed up the economic consequences in a note to clients: “The ‘stop’ in payments [from the Troika] would precipitate an immediate fall in economic activity, given the need to abruptly close the primary fiscal deficit (worth about 2.3 percent of GDP in 2011).”

“As government arrears (worth about 3.5 percent of GDP) fail to get paid, supplies to public sector companies (e.g., power, water supply) and hospitals would be disrupted and their output and activities curtailed. In this context, the inflexibility of Greek wages will result in higher unemployment, while product market rigidities are likely to imply sticky inflation (or even price increases),” warned Goldman Sachs. The rather academic tone of this analysis masks the human tragedy behind it, already happening now as the country is spiraling into poverty.

U.S. Markets Tumble on Financials

At the time of writing on Thursday, all major markets were deep in the red for the week. The euro lost 1.79 percent since Monday, dropping to $1.27 on Thursday afternoon. European stocks are down 4.9 percent for the week, with European banks underperforming, losing 8.7 percent.

But due to the intricate and interconnected nature of the global financial system, U.S. banks are not off the hook despite the fact that they are better capitalized and have less direct exposure to Greece.

The KBW US Bank Index is down 6 percent for the week, due to the fact that this crisis is not constrained to Europe. As has been seen with the MF Global Bankruptcy, turmoil in Europe can affect U.S. banks, who face counterparty risk in the form of derivative transactions should a large European Bank fail.

Next Steps

Politicians in Greece at this moment are not able to meaningfully contribute anything to solving this problem. As a consequence, the ball is now firmly in the court of the Troika. If they remain tough and cut off funding, Greece will hard-default and exit the euro, despite the fact that it could also default and stay within the euro system.

This, however, is unlikely according to Citigroup chief economist Willem Buiter, “Were Greece to be forced out of the euro area (say by the ECB refusing to continue lending to Greek banks through the regular channels at the euro system and stopping Greece’s access to enhanced credit support (ELA) at the Greek central bank), there would be no reason for Greece not to repudiate completely all sovereign debt held by the private sector and by the ECB.”

If they blink and keep on funding Greece, the loss of face could not be made-up and would be an open invitation to other countries like as Ireland and Portugal to not comply with the rules accompanying monetary aid.