The seemingly endless negotiations in the eurozone in recent weeks between Greece and its creditors overshadow a nearing reality: One day soon, the smoke will clear. When that happens, either Greece will still be in the eurozone or not, or there will be some mixture — a limbo state. Perhaps Greece will default on its loan but both sides will manage to strike a last-minute deal and keep the country in the club, at least for a while.
When that day comes, what will it mean for the eurozone and Europe’s brand? That is a critical question to ask as Greece gears up for a referendum on July 5. Meanwhile, the news reports on July 1 suggest that a deal may be in the works. According to The New York Times, Greek prime minister Alexis Tsirpas has sent a letter to the so-called troika — the heads of the European Commission, the International Monetary Fund and the European Central Bank — stating that Greece is “prepared to accept” a deal set out by the creditors, with small modifications to some key points of contention on issues like pension cuts and tax increases.
Meanwhile, though, hot debates are raging about whether Greece will be better off in or out of the eurozone. Mohamed El-Erian, former CEO and co-chief investment officer at PIMCO, predicts a “massive economic contraction” if Greece exits from the Eurozone. In contrast, Nobel Prize-winning economist Paul Krugman argues that a return to the drachma “couldn’t create that much more chaos than already exists, and would pave the way for eventual recovery, just as it has in many other times and places. Greece is not that different.”
How Will the Eurozone Fare?
Whatever the answer for Greece, what about the eurozone itself? Is it better off keeping Greece in the club and avoiding the breakup? Or, if Greece gets pushed or stumbles out of the club, then what will Europe’s fate be?
“Whether Greece exits or not, I don’t think this will have any serious consequences for the eurozone.”–Jeremy Siegel
Wharton finance professor Jeremy Siegel thinks Greece going its own way could actually boost the euro and the eurozone. He notes that the euro strengthened in the first day of trading after Greece announced its referendum plan, which had raised the odds of a Greek exit. But more fundamentally, the eurozone may have made an error when it admitted Greece to the eurozone in the first place. Siegel says officials “overextended” the admittance criteria and recent events prove Greece could not maintain the criteria, while the remaining countries can. A Greek exit would fix that mistake.
So if Greece is a weak link, then “… whether Greece exits or not, I don’t think this will have any serious consequences for the eurozone,” Siegel says. It is not likely to lead Spain or Portugal or others, to follow in search of a better economic environment. “The Spanish and Portuguese … for better or for worse they’re in it now and they consider an exit to be far more disruptive. Whether they should’ve gone in in the first place, of course, you could always speculate about, but given where they stand now they want to stay in it. I don’t think the Greek exit changes that situation or really threatens the position of the euro.”
Mauro Guillen, a Wharton management professor and director of The Lauder Institute, takes a different view. If Greece were to exit the eurozone, he says, it would further shatter the idea of monetary union and raise serious questions about Europe’s ability to manage its affairs. An exit “would be bad for everybody who remains in the eurozone because the eurozone is supposed to be a monetary union. But if one of its members exits, that means that it’s no longer a monetary union. It’s just a fixed exchange rate mechanism, and there’s a big difference…. A monetary union is supposed to last forever. A fixed exchange rate mechanism can last for five years or can last for 15.
“Just imagine if … Texas and the United States had to put in place those measures,” he continues. “That would mean that we would no longer have one single monetary space in the United States.”
Europe in Decline
That doesn’t mean that the euro — or the eurozone — will disappear anytime soon, Guillen says. He also believes that at this point it is best for Greece to remain a member and still sees only a 20% to 30% chance it will drop out. But what the eurozone is doing now goes far beyond the loss of monetary union. The “chaos” and “Twilight Zone” atmosphere in Europe give “the world the impression that Europe’s decline is irreversible. Over the last couple of years, Europe had already demonstrated that something is going awfully wrong. First was the Ukrainian crisis, where Europe has been totally paralyzed and unable to act against Russian aggression.”
“You can imagine that investors … don’t want to touch Europe. And so the problems with unemployment, with everything, will get worse if investors don’t want to bet on Europe’s future.”–Mauro Guillen
Another black eye for Europe, in Guillen’s estimation, is the crisis with African immigration in the Mediterranean — with hundreds “dying every year, and Europe has not been able to handle that. [Today is] the 10th or the 12th episode in the southern debt crisis, in which again, they agreed to something, and then somehow nobody lives up to the agreement”
In an opinion piece in the Huffington Post, Guillen added, “Europe is at the mercy of forces spinning out of control. The growth of emerging economies, an aging population, right and left extremism, and political corruption are threatening its future. So, Europe … is projecting an image of itself to the rest of the world that is inimical to the generation of confidence and trust. So you can imagine that investors, they really don’t want to touch Europe. And so the problems with unemployment, with everything, will get worse if investors don’t want to bet on Europe’s future.
“At all costs, the people who believe that the euro should remain in place should say ‘We cannot let any member of the eurozone leave it,'” Guillen writes. “But, regarding the potential default, I think what we’re talking about is a restructuring of the debt. And that would essentially mean that the lenders would lose money and Greece as a country would get better terms on its debt.”
Wharton finance professor Franklin Allen agrees that the costs to the eurozone of a Greek exit would likely be high. In a Knowledge at Wharton report from earlier this year, he noted that if Greece should exit, it would be the eurozone that by far ends up with the biggest problems. “Greece would probably come out of it in the medium term OK, although there would be a lot of uncertainty in the short term.” In the medium term, Allen added, Greece could “default on [much of its] debt. They’ve got a primary surplus and a lot of uncertainty would be gone.”
But the eurozone would have big problems of political contagion, “with politicians in other countries arguing they may also leave and negotiating harder [for better debt and austerity terms].” So, a Greek exit “may well cause enormous problems for the other countries,” Allen noted.
Other analysts have suggested that the problems of contagion Allen referred to might not show up in the near term because eurozone officials have had so much time to prepare responses to an immediate crisis. Instead, the trouble will surface when the eurozone hits the next big downturn — and other countries start to wobble in their support for membership. That will also depend on how Greece fares following the exit, if one occurs.
Wharton Dean Geoffrey Garrett acknowledges the big split in views over the fallout from the impasse in the eurozone. One view is that there won’t be contagion because people have known this may have been coming for years, he said in a Periscope interview about the crisis on June 29. “The other view is … no one really thought it would happen, and if Greece finally leaves there will be contagion in other weak European countries — Spain and Portugal, and maybe even Ireland — would be subject to runs from the financial markets. We don’t really know yet.”
“Greece’s population will suffer immensely because it finds itself between a rock and a hard place, namely, the monetary union and the demand for austerity measures.”–Mauro Guillen
The Main Problem
Allen further noted that the fundamental problem is that the eurozone “is simply not growing” — at least not fast enough to balance debtor economies. “The problem is that they have been making policy decisions based on growth forecasts which are ludicrously optimistic and completely out of line with what has actually happened. And this is the sense in which the policies have failed….”
Guillen agrees. Austerity policies lie at the heart of the problem,” he wrote in the Huffington Post. “Germany’s intransigence about balanced budgets is actually counterproductive. In a tightly integrated trade bloc, if every country pursues austerity, there is no slack demand to stimulate growth. Germany and the other surplus economies should serve as the locomotives through public, and especially, private spending.”
Others analysts have made similar points: “The current account surpluses of Germany and the Netherlands are heading towards 10% of gross domestic product per annum — a position that is neither sustainable, nor self-correcting: a bad combination,” Wolfgang Manchau wrote in one of his recent Financial Times columns.
And perhaps in the ultimate irony, one of the troika creditors, the IMF, admitted that austerity, in general, has fallen short of expectations. As reported in 2013 in the The Wall Street Journal: “… IMF Economic Counselor Olivier Blanchard and research-department economist Daniel Leigh show the IMF recommended slashing budgets too fast early in the euro crisis, starving many economies of much-needed growth.
“In ‘Growth Forecast Errors and Fiscal Multipliers,’ Messrs. Blanchard and Leigh calculate IMF and European economists underestimated the euro-for-euro effect of cutting government budgets. While economists expected that cutting a euro from the budget would cost around 50 cents in lost growth, the actual impact was more like 1.50 per euro. ‘We find that, in advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected, with the relation being particularly strong, both statistically and economically, early in the crisis,’ the economists write.”
In other words, trying to grow by shrinking spending as a policy — so-called expansionary fiscal contraction — has failed. Yet, eurozone creditors want Greece to continue on that path, Guillen notes.
“The situation created by the Greek debacle is devastating to the hopes of so many people, especially the unemployed. Greece’s population will suffer immensely because it finds itself between a rock and a hard place, namely, the monetary union and the demand for austerity measures,” says Guillen.
Allen also pointed out that when Argentina exited a dollar peg in 2002 (with parallels to Greece’s situation today), “it started growing again within a few months. And in a few years it doubled GDP.” Greece’s GDP is now 25% below where it was before the crisis began, “so there is potential to grow….”