Grexit contagion?

By Filip Abraham, Professor in International Economics at Vlerick Business School and KU Leuven

Once again the Greek saga dominates discussions in the Eurozone.  Reports from Athens are becoming more ominous by the day. As in previous months, questions are again being asked about the conditions under which Greece can remain part of the monetary union. Or whether an orderly Grexit should be planned instead. 

If all of this generates a strong feeling of déjà vu, take care.  The tone of the debate is shifting. Within the eurozone the conviction that Greece must remain part of the monetary union at any price is crumbling. Greece is heading for bankruptcy, as its government’s antics with regard to IMF repayments have made painfully clear during the past week. Avoiding a Greek collapse and keeping it in the eurozone would require renewed effort from the rest of the eurozone countries and there is little inclination for that. In financial circles, moreover, a Grexit is no longer viewed as a step that would quickly lead to the collapse of the eurozone. Indeed in recent years significant measures have been taken to ring-fence the damage from a possible Greek farewell and to solidify the euro construction.

As the more immediate disadvantages of a Grexit decrease, attention is turning towards the longer term consequences of a scenario in which a member country leaves the euro club. This debate is on the very essence of a single currency area, which is that participating countries irrevocably commit to give up their own currency. They commit to dealing with competitiveness problems by applying an internal adjustment process to their own economies, instead of relying on a depreciation of their currency.

This commitment lies at the foundation of the adjustment path followed by countries such as Spain, Portugal and Ireland. In return for the bailout packages financed by other euro countries, they introduced labour market reforms, accepted real wage cuts and embarked on painful austerity programs. The results are clear:  Ireland and Spain’s growth figures rank among the highest in the European Union, while Portuguese growth is picking up as well. And they did it without the disruption that a departure from the eurozone would have caused. The other side of the coin is an agonizingly slow adjustment process, with high unemployment figures and declining purchasing power.  This heavy toll could have been partially avoided if the burden of adjustment had been better balanced between the stronger and weaker economies. Without a doubt, solidarity mechanisms within the eurozone could be improved.

This recent experience illustrates the so-called internal challenge of a Grexit. Member States are only willing to come to Greece’s rescue if the Tsipras government accepts the adjustment path that Spain, Portugal and Ireland had to endure. A bailout without adequate reforms in Greece involves a substantial risk of internal contagion within the euro club. Countries that have pushed through difficult adjustments will rightly wonder why they had to suffer the pain. Struggling economies will in the future point to the Greek precedent to resist change. Without internal adjustments, the eurozone will eventually implode under the pressure of the divergent economic performances of its own members. For precisely these reasons, Greece will have to commit to structural reforms and budgetary discipline if it wants to stay in the eurozone.

 Suppose Greece does decide to leave the single currency area.  In that case the eurozone will face the external challenge of convincing the world that Greece is not the first of a whole series of countries that will bow out of the eurozone as soon as the pressure gets too much. In other words, the remaining member countries will have to contain the external contagion of a Grexit. This is no simple task. The conviction has long prevailed in the UK and US that the eurozone is a moribund construction that will collapse sooner or later. 

This brings us back to the essence of the monetary union. The eurozone will only gain definite acceptance from the outside world when one of its struggling member states is compared to, say, Michigan or California. These US states face profound structural problems of their own. Yet nobody expects them to leave the dollar zone and to depreciate their currency to put their house in order. 

Critics of the European monetary union argue that it requires a political union, with one country and one people. Advocates believe that a single currency is definitely possible among a group of sovereign countries with a number of peoples provided that clear rules exist and steps towards political union are taken. They view the ECB’s monetary policy, the single supervisory system for the banks and the budgetary rules as important milestones. What is lacking still is transparency concerning the balance between solidarity among member states and the individual responsibility of each eurozone country. The conditions under which countries in difficulty can call on financial support from the other member states of the monetary union and the extent to which they may do so must be defined. Clear agreements must be made on the use of loans, debt relief, investment aid and other financial instruments. That is quite a job and time is short. 

Meanwhile, the decision on a Grexit means eurozone governments are faced with a difficult trade-off between internal and external contagion. They would prefer not to have to make the trade-off, but that will only be possible if a Grexit is avoided and Greece is persuaded to accept the harsh rules of the euro game. That policy choice clashes with the stubborn and capricious attitude of the Greek government. The coming weeks should reveal whether this approach has any chance of success. If not, Greece and the eurozone are in for a period of turbulence and gloom.

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