Greece, Default and Contagion: the prodigal son

by George Hatjoullis

The press continues to debate the subject of Greece in terms of exit and contagion. As my many blogs on the subject have tried to explain this is not valid. Greece may default (indeed almost certainly will in some way) but this does not imply exit. At worst its banks will be cut off from Emergency Liquidity Assistance and TARGET2. This will be bad for Greece (and the eurozone) but does not require Greece to formally leave the eurozone or EU. There is no mechanism for forcing Greece to leave. The eurozone can merely make it very uncomfortable. There are many scenarios where such a situation can proceed and there is no point in elaborating until the situation arises if indeed it does arise.

The second point is contagion. There is no risk of contagion (none at all). The creditors are primarily official institutions which can absorb the shock. The contagion of 2010 would have been via banks and in terms of the knock on effect on the behaviour of other peripheral member states. The banks are no longer vulnerable to a Greek default. The other peripheral states have successfully gone through painful adjustment programmes and are not about to jeopardise their eurozone credentials by back-tracking now. Indeed these states are part of the problem for Greece because they will not let Greece off the hook.

The reality is that Greece’s adjustment has been far more severe than any other eurozone state (including Cyprus so far) and has reached an unbearable level.It was always obvious that it would need to be so severe. It was unwise to impose such a severe adjustment programme on Greece as it was bound to fail. It has failed. The situation is succinctly summed up by Yanis Varoufakis;

Our task is to convince our partners that our undertakings are strategic, rather than tactical, and that our logic is sound. Their task is to let go of an approach that has failed.

It is, as I have written before, incumbent on the eurozone and friends to recognise the error and let go of this failed approach. This does not mean letting Greece off the hook. Ultimately, the objective must be to restore Greece to health and allow them to be a productive member of the eurozone. This means modifying the existing adjustment programme. Forcing Greece to default will help no one. The eurozone has come through a terrible crisis relative unscathed. Greece is the last remnant of this crisis in some respects (ignoring lost output and still high employment levels). The eurozone would do well to cut their losses and move on. It will help the whole region. Perhaps Schaeuble should re-read the parable of the prodigal son.

All is contained, if turbulent, provided Greece does not choose to formally exit. The real risk to the eurozone is if Greece, somehow, ends up leaving the eurozone. The irrevocable nature of membership is then destroyed. This will have unknown consequences and open up new dangers. However, this seems unlikely so it should not be the focus of debate…yet.