The Economic Consequences of Greek Exit from the Euro

With just over a week to go before the Greek General Election, it is reported that the left-wing Syriza Party may emerge with the most seats and be invited to form a government led by Alexis Tsipras.  His economic policy is based on two pillars:

1. Greece should remain within the Euro.

2. However, Greece should not continue the policies of austerity pursued by the government of George Papandreou to comply with the EU’s fiscal compact, which would require Greece to balance its budget. Instead, Mr Tsipras proposes the creation of 100,000 public sector jobs and writing off part of the country’s debt.

There is a logical third implication of this syllogism:

3. Germany and the other Eurozone countries should transfer sufficient resources to Greece to enable the Government to meet its public spending and debt servicing obligations.  Without this, the Greek Government could become insolvent.

[3]  is not going to happen. In an excellent presentation given to the David Hume Institute in Edinburgh yesterday evening, the Prime Minister of Lower Saxony, Mr David McAllister, made it very clear that, whatever his personal sympathy for the predicament of the Greek people, there was no possibility that he or his national party leader, Angela Merkel, could sell such a proposal to their voters. He pointed out that the retirement age in Germany had only recently been raised to 67, against strong trade union opposition, and there was absolutely no way that German voters would support subsidies to the Greek Government to enable it to maintain an average retirement age of 61.

Given these political realities, the most likely outcome is eventual Greek exit from the Euro.

The consequences of such an exit are a matter for debate.  Nikolaos Karamouzis of Eurobank was quoted in the Sunday Times on May 20th as saying, “We depend on EU and European Central Bank funding to pay our back our debts and keep everything from banks, to hospitals, to the traffic lights working. If the EU stops funding us, we will simply run out of money and the economy will stop functioning.” In the “armageddon scenario” painted by the Sunday Times, “an implosion in Greece would spread to Portugal, Ireland, Italy and Spain, sparking runs on their domestic banks….Stock markets would crash….There would be a flight of capital from weak to strong countries, necessitating exchange controls.  Governments might seize assets held by foreigners.  Inflation would soar in Europe’s periphery, but core nations could suffer deflation….Unemployment would soar.  Public services would fail….House prices would plummet…”

However, such a nightmare scenario is not borne out by historic precedent. Twenty years ago, Britain exited the European Exchange Rate Mechanism – the precursor to the Euro.  Sterling did indeed drop significantly in value, as a new Greek Drachma would against the Euro. But Britain did not descend into social and economic chaos.  On the contrary, the years following ERM exit saw a sustained recovery in output, income and employment in the UK.  I believe that the same would happen in Greece.  The price of Greek agriculture, manufacturing and tourism would fall as a result of a Drachma devaluation against the Euro. After an initial shock, the Greek balance of payments would gradually improve – just as the UK balance of payments did in the mid-1990s – as exports became more competitive, while domestic production became cheaper relative to imports. As in Britain after the ERM exit of September 1992, the most likely scenario is that the Greek economy would trace a “J” curve – an initial downturn followed by gradual and sustained recovery.

The adjustment process would be eased if transitional assistance were provided to Greece by the IMF as part of an orderly exit, as proposed by the highly respected Chairman of the House of Commons Treasury Select Committe, Andrew Tyrie MP, in a paper published by the Centre for Policy Studies on June 5th.

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  1. Surely a drop in the exchange rate increases the costs of imports – effectively a significant drop in the standard of living of the Greek people as they find the products they want to buy have gone up in price. So any surge in growth first has to offset this drop in the standard of living before it can be said to be an improvement.

    It seems to me to be inflationary. Plus I assume at least some of the imports will be used in the manufacture of the products Greeks export. Who is to say that such an increase in production costs for Greek exports will not offset the drop in the value of the Greek currency?

    1. Provided that the Greek Government and Central Bank apply appropriate policies, any inflationary impact as a result of devaluation – which I agree would occur as import prices would increase – would be restricted, enabling the benefits of a competitively valued Drachma to feed through in higher exports and lower imports. “Who is to say” – my reference is the historic evidence of actual devaluations that have occured following a currency’s exit from an inappropriate currency union – including the UK after 1992, which is why the UK (very wisely) opted not to abandon the £ in favour of the Euro.

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