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Why Greece Will Leave the Euro

Friday, December 6, 2013

As Greece's political and economic conditions worsen, the conventional wisdom about Greece never abandoning the euro will be sorely tested.

According to an old Wall Street adage, when the winds are strong even turkeys fly. If ever there was a case to which this adage would apply, it would be that of the market’s present favor for Greek government bonds. Over the past year, as the market has stretched for yield in a low interest rate global environment, the Greek government’s long-term borrowing cost has declined from over 18 percent to its present level of 8.5 percent. And it has done so despite increased signs that Greece lacks the political willingness to resolve the many deep-seated problems that still characterize the Greek economy. 

Anesthetized by ample global liquidity, markets are simply choosing to ignore many warning signals emanating out of Greece about that country’s political and economic future. They certainly seem to be turning a blind eye to the Greek government’s insistence that Greece has reached the social and political limits as to how much more budget austerity and painful structural economic reform the country can tolerate. They also seem to be disregarding Greece’s stalled IMF-EU negotiations and increased signs that its foot-dragging on real economic reform is causing Berlin’s patience to run out.

Over the past three years, Greek wages have declined by around 10 percent, while over the past year consumer prices have fallen by almost 2 percent.

A troubling indication that Greece may now be on a collision course with its official creditors was the Greek government’s recent presentation of its 2014 budget without the blessing of either Brussels or the International Monetary Fund. According to the IMF, Greece’s 2014 budget has an unfinanced gap of around €1.5 billion. The IMF also notes that Greece’s efforts at structural economic reform have fallen far short of the country’s commitments under its IMF-EU program, especially in the areas of public sector layoffs and privatization policy. This lack of progress would seem to make it highly improbable that Greece’s official creditors would agree to yet more bailout funds.

Markets also seem to be totally discounting the possibility that the Greek government could fall next year and that the far-left Syriza party, which is not known for supporting the IMF-EU policy prescriptions, could be swept to power. They do so despite the deep divisions that are now clearly apparent in the Samaras coalition government, which has already seen its majority in Greece’s 300-member parliament whittled down to only three members. They also do so despite the very real likelihood that the Greek government will suffer a humiliating defeat in the May 2014 European parliamentary elections that would make it difficult for it to continue governing.

Equally surprising is the market’s apparent equanimity about Greece’s dismal economic outlook, which seems to be driving its political fragmentation. Despite the fact that Greece’s economy has contracted by almost a quarter over the past six years and that Greece’s unemployment rate is around 28 percent, both the OECD and Moody’s are forecasting another small decline in Greek GDP in 2014. They are doing so in recognition of the additional budget tightening that Greece has to undertake to put its public finances on a sounder footing as well as of the ongoing domestic credit crunch that is making it difficult for households and companies to obtain much-needed bank financing.

Anesthetized by ample global liquidity, markets are simply choosing to ignore many warning signals emanating out of Greece about that country's political and economic future.

Another concern is that Greece is experiencing outright price and wage deflation. Over the past three years, Greek wages have declined by around 10 percent, while over the past year consumer prices have fallen by almost 2 percent. Given the very large gaps characterizing Greece’s labor and product markets, we should expect that Greece will continue to experience wage and price deflation for a prolonged period. Judging by Japan’s experience with deflation over the past two decades, we can expect that falling wages and prices could very well thwart a Greek economic recovery. And deflation could make it impossible for Greece to deal with its public debt mountain without substantial official debt relief.

In hoping that Europe will somehow endlessly ride to Greece’s rescue no matter what happens in that country, markets might want to reflect on a couple of sobering precedents. Prior to Russia’s July 1998 default, that country was widely believed by markets to be too nuclear for the G-7 to allow it to fail. And prior to Argentina’s 2001 exit from the Convertibility Plan, markets thought that the IMF and the U.S. Treasury would never allow that to happen.

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

FURTHER READING: Lachman also writes “Europe’s Deflation Challenge,” “5 Economic Lessons Europe Can Learn From Greece,” “Time for Greece to Leave the Euro,” and “Who Lost Greece?” Tino Sanandaji explains “The American Left’s Two Europes Problem.” Lee Harris describes “The Hayek Effect: The Political Consequences of Planned Austerity” and James Pethokoukis shares “The 1 Chart that Shows America Is Not Greece — Yet.”

Image by Dianna Ingram / Bergman Group

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