What We Know and What We Don’t: Greece’s Future in Europe
Let’s be frank: we are all guessing right now when we project the future of the high-stakes negotiations between Greece and the rest of Europe. My crystal ball blew a fuse and completely failed to predict that Prime Minister Tsipras would call a referendum in Greece for next Sunday, requesting support for rejection of the current European proposals. Judging by the commentary, it caught virtually everyone else by surprise, too. This is both an illustration of the difficulty of predictions in this fraught situation and is a game changer in its own right that makes the immediate future even murkier. Yet the larger fundamentals have not changed, so this is a good time to review what we can reasonably know and what is simply unknowable at this point.
Politics and the Negotiations
We know that there is a middle ground to which the Greeks and their European creditors could move which would allow all the relevant governments to claim at least partial victory. The broad outline of such a deal has been visible for months and the proposals of both Greece and its European creditors are already in an area that could be accepted by the other side under the right circumstances. It therefore remains quite likely -- although far from certain -- that the two sides will eventually find reluctant agreement, albeit with considerable further economic and political pain possible before they get there.
We know that the broad majority of the Greeks want the country to stay in the Eurozone while also gaining significant changes to the austerity and structural reforms previously agreed with the Europeans. The problem is that these two desires are at least somewhat contradictory, given what Greece’s European partners are demanding in exchange for the financial support that is likely necessary to enable Greece to stay in the currency zone.
We do not know how the referendum will come out. Many market analysts outside of Greece are predicting a “yes” to the European offer, based on the interpretation of previous polls that show strong support for keeping the euro “at all costs.” However, this ignores: (a) the conflict between the voters’ desire for the euro and their strong wish for an end to austerity; (b) the unreliability of polls in such unsettled circumstances; (c) the ability of events over this week to change views considerably; and (d) the fact that the exact wording of referendum or poll questions can swing voting results by 10 or 20 percentage points and the Greek government determined the wording. In the end, we just do not know how people will vote.
The Economic Impact of Continued Conflict
We know that the rest of Europe will feel some of the pain induced by all the uncertainties, but at a much reduced level compared to what Greece will suffer. Business and consumer confidence will be damaged, stock markets will decline at least modestly, and interest rates in the other European countries that are perceived as relatively weak, such as Portugal and Spain, will likely rise in comparison to German rates as money flows to “safe havens.” So far today this has indeed been the market reaction, with core European stock markets down about 3 percent and peripheral markets down further. As for bonds, peripheral sovereign yields are up about a quarter of a percentage point or less, while Germany and other core European markets are seeing yields declining by a tenth of a percentage point or so. In brief, markets are viewing this development as bad news, but not horrible news.
There will be spillovers into the rest of the world, including America, although none of them are likely to be serious in the context of our overall economies. Ironically, the American economy may be pulled down slightly and the European economy helped by a fall in the value of the euro versus the dollar. (It has fallen about 1 percent so far today as of 8am.) Our stock markets may suffer as well, to some extent, from greater fears about the world economy as the European motor faces the risk of sputtering a bit at the same time as China is already slowing down from previous rapid growth levels.
We almost certainly know that if Greece does fall out of the Euro, its economy will initially go into sharp recession. The transition would be very ugly as businesses and consumers pull back aggressively in response to a huge increase in uncertainty.
We do not know how much more strongly markets would react if Greece actually does exit the euro. Markets are pricing in a probability that a deal will eventually be reached, which still seems the most likely scenario. The effect of a full Greek exit would likely be a multiple of what we are seeing from the weekend’s news, but would still probably fall into the “bad news” bucket rather than the “horrible news” one. There are two fundamental reasons for my belief. First, it is worth underscoring that Greece is simply not that big -- it is only 2 percent of the overall European economy. Second, European authorities, especially the European Central Bank, will intervene heavily to counter the negative effects on the rest of the Eurozone from a Greek disaster. Further, the contagion risks are not daunting in the short term because nobody expects that Portugal or Spain or Italy is on the brink of creating their own version of the Greek crisis. They all want to stay in the Eurozone and the remaining debates about austerity and structural reform are less pressing in those countries, partly because their economies are mostly growing again.
We do not know what the long-term effects on Greece would be of exiting the Eurozone. I believe it will be worse off in the long run outside the Euro, but the effects beyond the initial adjustment period are open to debate and there are those who think Greece would eventually be better off. A major reason I disagree with them is that they tend to implicitly assume that the Greeks would adopt all the right monetary and fiscal policies once they are on their own, which I doubt strongly. First, it’s too difficult a feat for anyone; critical mistakes will be made. Second, there is no particular reason to expect a Syriza government to manage the economy well, nor have the parties previously in power gained my confidence. Greece has a somewhat dysfunctional political system and exit from the Euro will not magically cure this.