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A Tale of a Euro Exit Foretold

Tuesday, July 5, 2011

Whether through bailout fatigue, austerity fatigue, or a full-blown bank run, Greece’s exit from the euro is now inevitable.

Having spent a long career at the International Monetary Fund and on Wall Street looking at currency crises, by now I believe that I know a currency regime's endgame when I see it. Sadly, Greece is now displaying every sign of having entered the endgame of its euro membership. And European policy makers would be doing their constituents the greatest of disservices by remaining in denial about the severity of Greece's present condition and by not making contingency plans for Greece's exit from the euro within the next six to twelve months.

Experience with earlier currency crises should inform one that there are a number of distinct ways that Greece could be forced to leave the euro. The most obvious of these ways would be if Greece's main financial backers, Germany and the European Central Bank, succumbed to "bailout fatigue" and turned off the financing spigot that presently keeps the Greek economy afloat. Since, without that financial support, Greece would have little alternative but to default on its debt and to leave the euro.

In a moment of candor, Jurgen Stark, the ECB's chief economist, recently observed that a Greek default would likely precipitate a European banking crisis on the scale of that which occurred in the wake of the 2008 Lehman bankruptcy. With the stakes of a Greek default so high, it is reasonable to suppose that the European political elite will somehow find a way to overcome mounting electoral disapproval and stitch together a second bailout package for Greece.

European policy makers should make contingency plans for Greece's exit from the euro within the next six to twelve months.

However, until recently backing down, German Chancellor Angela Merkel's initial insistence, despite the vociferous objection from the ECB, that any second Greek bailout package be accompanied by some form of private-sector burden sharing should be seen as a strong indication of mounting German public resistance to further bailing out the periphery. It should also be seen as yet another sign that limits are now being reached as to how much further the Europeans can kick the Greek can down the road through further large bailout packages.

A much more likely way by which Greece could be forced to leave the euro would be if domestic austerity fatigue were to intensify—without domestic public support, there would be little chance that Greece could continue to hue the austerity line of the International Monetary Fund and European Union. And should Greece not remotely comply with the IMF-EU adjustment program, there would be little chance that Greece could continue to count on the IMF-EU financial support so necessary to keep Greece afloat.

Sadly there are increased signs that austerity fatigue is on the rise in Greece. Against the backdrop of mounting public anger about additional austerity measures and about the IMF-EU's insistence that Greece privatize up to €50 billion in publicly owned assets at fire-sale prices, Prime Minister George Papandreou has been forced to reshuffle his cabinet in a desperate attempt to remain in power. At the same time, the large daily protests at Syntagma Square and the increasing labor unrest have to be seen as the clearest of signs that Greek public patience is running out with the ordeals of IMF hair-shirt adjustment.

Large daily protests at Syntagma Square and the increasing labor unrest have to be seen as the clearest of signs that Greek public patience is running out with the ordeals of IMF hair-shirt adjustment.

Yet a further, and likely the most probable, way that Greece could be forced to exit the euro would be if it were to experience a full-blown run on its banks. Recent developments on this score have been far from encouraging. Over the past 18 months, Greek banks have lost over €40 billion, or around 18 percent, of their deposit base and they are now reportedly losing over USD$2 billion in deposits each week. Equally ominous, in the last quarter of 2010 alone, European banks cut back their loan positions to Greece by more than €20 billion.

Heightening the probability that Greece will be forced to exit the euro within the next six to twelve months is the strong likelihood that there will be a further substantial deepening in Greece's painful economic recession. Over the past 18 months, Greece's economy has already contracted by 9 percent and its unemployment rate has risen to above 15 percent. There is every reason to now expect that further IMF-style belt tightening within the euro straightjacket, which will require a further 3 percentage points of GDP cut in public spending in 2011 alone, will exacerbate that recession.

European policy makers ought to anticipate that a material deepening in Greece's recession is bound to further erode Greece's tax base and make it all too likely that Greece will need even more bailout funds. They would also be remiss not to anticipate that a further downward lurch in the Greek economy could heighten Greece's austerity fatigue to the breaking point and could create those very conditions that would precipitate a full-blown run on Greece's banks. At this critical stage in the Greek crisis, the worst thing that European policy makers can do is to remain in denial. A disorderly Greek default, coupled with a forced and untimely euro exit, could prove Jurgen Stark to be justified in his worst fears about the possibility of a second Lehman-style crisis for the European banking system.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman has recently written “Ms. Lagarde’s Poisoned Chalice,” “Greece’s Unhappy Anniversary,” “Repeating Europe’s Charade,” and “Till Debt Do Us Part.” He has also published “Partial Debt Restructuring Will Not Work” and “Is There Any Hope for Greece?” Other related articles include, “Athens on the Potomac” by Veronique de Rugy and “Toward a More Perfect (European) Union” by Vincent R. Reinhart.

Image by Darren Wamboldt/Bergman Group.

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