The Economic Implications of a Greek Default

A lot of media attention has recently been focusing on the potential for a Greek default and exit from the Eurozone, and last Tuesday night Greece failed to repay its IMF loan, becoming the first developed country to default with the IMF. Last Sunday Greece also imposed capital controls to prevent capital flight from occurring. Capital flight is the situation whereby residents and firms move money out of a country because they are scared that they will otherwise lose it. This may be due to government taxation, requisition (some Cypriots who had money deposited with banks lost 25% which was taken by the government through an emergency tax in 2013) or fear of bank collapse. To prevent this capital flight from happening the Greek government ordered banks to close until after a referendum – asking Greeks whether they wish to accept punitive loan measures or resist austerity measures – takes place (which it did yesterday, where the No vote won) and restricted the amount of cash which can be taken out of ATMs and out of the country for fear that Greeks will move their money to a safer German bank. Some are claiming that these capital controls are sufficient for a Grexit (after all one of the founding pillars of the eurozone is free capital mobility, but remember that Cyprus had capital controls for a period in 2013 but was able to remain in the eurozone and re-open capital markets). What would a Grexit mean for Greece, the EU, Britain and the rest of the world?

How would a Grexit effect Greece…

Bear in mind that all the following analysis is speculation and based on very narrow assumptions, furthermore, I have quite a pessimistic view, any other views would be welcome in the comment section below…

If Greece were to leave the Eurozone then it would face mass capital export as people would move their money abroad to safe havens including Germany – although they may decide to avoid leaving money in the eurozone altogether for fear of a complete collapse – the UK and the US. This article also suggests that Bitcoins are doing well as an alternative form of currency from the Grexit risk, although it notes that there are only a few thousand Greek customers with an average deposit of 700 euros. The reason for such capital export may be due to a fear of bank collapses – who would no longer have access to European stability cash and would face mass deposit withdrawals by customers creating a self-fulfilling prophesy of collapse – and emergency government taxation. The vast capital outflows would, amongst other things, cause a massive decrease in investment and consumption as consumers and businesses are reluctant to spend; either because all their money is now abroad, or because they fear they would be unable to access funds in the future. If a lot of money flows abroad – or under people’s mattresses – then it isn’t available to lend and thus investment sources dry-up and interest rates rise making it more expensive for firms to borrow to invest, limiting economic capability and growth. This has particularly pernicious effects in the long run which could inhibit Greek growth for generations. It is likely that the Greek government would impose capital controls (much like it currently has, although perhaps more strictly), but under such conditions they may not be successful if people and firms are adamant to remove funds.

Consumption accounts for around 60/70% of a Western developed country’s GDP with Investment normally around 15%, thus a fall would be seriously detrimental for Greek GDP which has already fallen significantly since the Great Recession. Tourism – which accounts for 18% of Greek GDP – would likely fall too, as foreigners worry about the currency situation. Large defaults and firm closures may incite fear abroad that holidaymakers could become trapped (e.g. if an airline fails) or have their holiday ruined (the hotel closes down). On the other hand, the new currency may mean holidays are so cheap that tourism is boosted.

Greece would likely return to the drachma, which would depreciate significantly on the foreign exchange market. This would make exports more internationally competitive and so may provide a boost to the Greek economy. Furthermore, tourism may be boosted as £1 purchases more drachmas meaning holidaymakers have more to spend in Greece encouraging them to travel. However there may be a lag in the time it could take for Greek industry to take advantage of a weak currency; for example hysteresis effects may mean that there is a lack of capital goods available to increase output for export demand. This would lead to higher inflation as supply-side weaknesses prevent the economy from expanding to meet increased export demand. Added to this inflation is exchange rate inflation caused by more expensive imports as a result of the devalued drachma. Whilst it is true that import substitution – replacing foreign-made goods with home made goods – could entail, it’s unlikely due to the even longer lag than for increasing exports. For import-substitution to be successful the Greeks would have to gain the knowledge and technology – as well as patents and licenses – to create the goods and services which were previously made abroad. Also, don’t forget that more expensive imports would increase costs (assuming import-substitution hasn’t yet occurred) for the export industries which would reduce some of the cost-advantage gained from the devaluation.

Having its own currency may be more advantageous to Greece in the long run than remaining within the eurozone. We have already seen that with its own currency Greece would be able to devalue and potentially increase exports which would boost aggregate demand and hopefully increase employment. The only way it could see export-led growth remaining in the euro is through painful deflation. It would need to allow market mechanisms (which may be hindered by necessary safety valves such as a welfare state) to let wages fall low enough that Greek goods become competitive on the international stage. This may be difficult with eurozone-wide deflation because Greece would need to see even larger deflation to get Greek prices lower than its European competitors. Allowing these market mechanisms to work could take a lot of time as well as pain. On the other hand, reverting to drachmas would cause much confusion as to the value of contracts and wealth which people have in euros. If a Greek mother hand 500euros in the bank, what would this become with the introduction of the drachma? Would the Greek government exchange it at the market value; in which case that mother would receive a lot less purchasing power in drachmas than she had in euros. What would happen to a German-owned hotelier whose contracts would likely be turned into worthless drachmas? I don’t know the answer to these questions, but it probably wouldn’t be good news for the Greeks.

On the subject of hysteresis, it is relevant in this situation as much capital would have depreciated since 2008 as factories and machines are left idle from firms going bankrupt and not utilising – and thus maintaining – equipment. This means that if the economy suddenly had a massive surge in demand for the production of goods that it wouldn’t be able to fulfill this because it would need time to fix up the machines/factories and create more capital goods. Similarly, workers who have been laid off by the recession and ensuing sovereign debt crisis may have forgot their skills or become disillusioned with the workforce and thus exited (cognitive dissonance), whilst some workers may return to the labour force if wages were to rise some would be lost forever. It is also likely that a Grexit would mean mass outflows of people (as well as capital) because people look for jobs elsewhere or wish to avoid tax increases which would probably be necessary. Whilst this would reduce unemployment it would only have a statistical effect and would reduce tax revenues (e.g. from income tax) although it may lead to lower spending. It may be the case that those who leave are some of the most talented and most able people, again, causing long term problems for the country by exacerbating the leftward shift of the long run aggregate supply curve.

Taxation would likely increase dramatically as it would be unlikely that Greece would be able to easily borrow on international markets, and other organisations such as the IMF may be reluctant to give the country a loan following its default with the Troika. A country has 3 sources of finance for government spending: taxation, borrowing or printing money (seigniorage). We have already said that borrowing would be an unlikely source and it is furthermore unlikely that a non-eurozone Greece would want to print vast amounts of money; at least in the short run. Say that it did then it would mean an increase in the supply of money which would mean that a single unit of currency (presumably the Drachma) would become more worthless. Bearing in mind the currency has already been significantly devalued on an international stage the government should avoid further devaluation by printing money as this would increase the pain from higher inflation which could eventually manifest itself as hyperinflation. This only leaves taxation as a source of revenue, hence if Greece wanted to continue spending the same amount as it currently does it would need to increase tax collection alongside higher rates. Of course it could simply reduce spending, but this would be even worse than the austerity “imposed” upon it by the Troika, which the Syriza government has been trying to ameliorate. Higher taxation would be difficult to swallow politically, despite its necessity, especially as the fall in business activity would reduce government revenues in itself.

Some commentators believe that an exit from the Eurozone would, by default, mean an exit from the European Union. If this were the case then Greece would no longer receive access to the Single Market (until/unless it signed an agreement similar to Switzerland or Norway giving it access without formally being in the EU) causing a massive fall in exports which may offset the devalued drachma. Furthermore imports may become more expensive (presumably the government would introduce tariffs to increase revenue – another partial benefit: for the government at least) increasing inflation even further.

On the upside the Greeks would have absolved themselves of debt and debt repayment and would therefore be able to spend more for domestic purposes. We have already seen that the devalued drachma may mean more export demand and greater tourism. Removal from the EU could lead to a source of revenue from the imposition of tariffs. Whilst these are minor benefits they are mainly a side-effect of a negative rather than a benefit in its own right. There are very few “actual” benefits from a Grexit, to Greece at least. Perhaps this will lead to a resolution if Greece realises the absolute pain which would be caused from an exit and politicians privately know that this has to be avoided at all costs, despite the publicly issued rhetoric.

How would a Grexit affect the EU and Britain…

Contrary to the size of the media attention Greece only accounts for 1.7% of the Eurozone economy. Yet an exit would likely harm the European economy much more than this figure states and would cause ripples we couldn’t foresee. Firstly, many European banks would lose a lot of money which they had lent to Greece when it defaulted, along with firms who had assets in Greece which would become worthless with the introduction of the drachma and conversion of euros. It is unlikely that this would cause bank failure in the rest of Europe, as the ECB is aware of this threat and is supposed to have carried out stress-tests to ensure that banks are well financed. In any case, it would provide emergency liquidity to prevent further collapse and contagion in the rest of Europe, but bank runs may be inevitable, particularly in the economies of other PIIGS (Portugal, Ireland, Italy, Greece and Spain) and more tax-payer bailouts would be necessary.

Secondly, bond yields in said PIIGS countries would rise as the private sector believes there is an increased risk of other countries leaving the eurozone now a precedent has been set. Higher government bond yields cause other interest rates in the economy to rise and mean the government has to spend more of its resources on interest-rate payments than providing services or investing for the future. As a result it may need to trim back on expenditure elsewhere, to the detriment to the real economy. Alternatively it may feel the need to raise taxes, which again would harm the real economy. This precedent – of it being possible to exit the eurozone – may eventually, or even more immediately, cause a breakup of the rest of the eurozone, but it isn’t worth analysing that outcome here due to the various possibilities this would entail.

To further exacerbate the situation, the Greek exit may prompt politicians of a certain ilk to call for more austerity to prevent any further escalation (of course, I dont agree with this and would hope that politicians would see that austerity has failed, alas this is unlikely).

The euro would probably fall in value which would help boost exports, although again imports would rise causing inflation (this may not be a bad thing: there is a current fear that Europe is succumbing to the more dangerous deflation). Greece would still be more competitive than Europe, because the drachma would fall much further than the euro, but Europe should still benefit from an increase in competitiveness against its main trading partners.

Turning briefly to the effect on Britain it is likely that exports would fall for two reasons:

(i) the pound would be stronger than both the euro and the drachma, so imports will rise whilst exports will likely fall. This is significant as around half of our exports go to Europe.

(ii) there would be mass panic and uncertainty on the continent which will, most likely, lead to a decrease in consumption and investment, thereby affecting demand for British goods and services

This could have much more serious affects for Britain than a slight decrease in aggregate demand: a weak economy in Europe would provide even less of an incentive for Britain to remain within the EU and would give eurosceptics greater bargaining power in fighting for an exit. Moreover, they would grasp upon the fact that Greece has left and try to use this to convince the public that Britain is better off out of the EU.

How would the Grexit affect the Rest of the World…

The economic effects probably won’t be that large for the rest of the world (RoW) from an actual Greek exit. The greater effect will come from market panic, and the fall in consumption/investment caused by greater uncertainty in Greece, the EU and Britain. The risk of bank contagion could cause some problems, and it may well be that we see liquidity and credit begin to dry up again as banks fear lending to each other as they don’t know who has exposure to Greece. Hopefully, central banks have learnt their lessons from the Great Recession and would be able to quickly act to prevent this happening, or at least mitigate the effects of this.

 

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