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The Daily Need

A ‘Grexit’ primer

The swelling protests, marathon summits and market panic can only mean one thing: the eurozone is gearing up for its third consecutive summer of slogging through its never-ending debt crisis.

After a brief respite, Greece once again finds itself on the brink of a financial collapse. Last month, Greek leaders were unable to form a coalition government after the May 6 election, which was largely seen as a rebuke of unpopular austerity measures that have ravaged Greek civil society. A repeat election has been scheduled for June 17, and it has been widely cast as a referendum on Greece’s membership in the eurozone.

European leaders have made it clear that compliance with previously negotiated austerity programs is a precondition for continued eurozone membership. However, Greek citizens have clearly signaled their growing intolerance for the successive government cuts that have taken a dramatic toll on living standards over the past two years.

This impasse has spurred some policymakers to openly acknowledge the contingency plans that are being drawn up in the event of a Greek exit – or Grexit –  from the eurozone. Once seen as an improbability, Greece’s eventual departure from the currency union is now viewed as all but inevitable. While some European policymakers have recently issued statements about a “managed exit,” many believe that the absence of any legal framework governing a country’s departure from the euro would all but guarantee a chaotic chain reaction that would have global ramifications.

Déjà vu?

You might be asking yourself, haven’t we been here before? The short answer is yes – several times. At the tail end of 2011, Europe’s debt crisis seemed to be entering a critical phase as a sweeping credit crunch took hold across the continent: the dreaded “Lehman moment” looked imminent.

President of the European Central Bank Mario Draghi. Photo:

But in the eleventh hour, the then newly appointed head of the European Central Bank, Mario Draghi, managed to stave off disaster by lending European banks a seemingly unlimited amount cash for a three-year term at a 1 percent interest rate. This “long-term financing operation,” or LTRO, allowed banks to buy government bonds, which in turn reduced interest rates for imperiled countries like Italy and Spain.

By not lending directly to governments, Draghi was able to preserve the veneer of central bank independence and not violate any standing European treaties. His dexterous maneuvering in providing backdoor funding to states bought European politicians time and was widely praised by policymakers on both sides of the Atlantic. Time magazine’s Fareed Zakaria went so far as to hail Draghi, also known as  “Super Mario,” as “the savior of Europe.”

Austerity and its discontents

While the central bank’s cheap money bought leaders time to implement broader political solutions, it failed to address the core solvency issues in countries like Greece. For demand-side economists, the German-backed austerity measures have only thwarted Greece’s efforts to return its troubled economy to health. Paul Krugman and others reason that laying off thousands of workers and cutting pensions during an economic downturn are counterproductive as they weaken consumer demand and reduce government revenue – a downward spiral that usually requires even more bailouts and cuts.

Bleak economic data lends credence to this death-spiral theory: Greece’s unemployment rate hit 21.7 percent this past February; youth unemployment rose to 54 percent. Greece’s GDP has shrunk by 17 percent since the start of the recession five years ago. And its economy is forecast to contract another 5 percent this year. More importantly, the country faces years of painful cuts and “internal devaluations” before it regains competitiveness, should it remain in the eurozone.

The backlash

A protester shouts slogans during a May Day protest in Athens, Tuesday, May 1, 2012. Photo: AP Photo

Not surprisingly, the country’s rapidly deteriorating economic situation has upended Greek politics, with established parties like New Democracy and Pasok losing support, and newer extremist parties like the right-wing Golden Dawn and hard-left Syriza parties making significant inroads on anti-austerity platforms in last month’s legislative election. With leaders unable to form a coalition government, Greece is now preparing for a runoff election on June 17, which some say will decide the fate of the country’s membership in the monetary union.

The backlash against the bailouts and austerity measures highlights the ways in which these unpopular policies are incompatible with democracy. To Greek constituents, the “troika” of the European Commission, the European Central Bank and the International Monetary Fund (IMF), which collectively share responsibility for negotiating bailout packages, is largely seen as a band of foreign occupiers that have little regard for the country’s sovereignty and its citizens welfare.

But the full force of the public’s ire has been directed at German leader Angela Merkel, whom Greeks fault for championing unpopular reforms. The anti-German sentiment has also reopened longstanding grievances about the Nazi occupation of Greece during WWII, which the Greek media has exploited to great effect by portraying the chancellor as a modern day SS officer. Clearly, the current economic crisis has undermined the ultimate goal of the European project: “ever closer union.”

A game of euro-chicken

In the run up to the June 17 elections, European leaders and the Greek electorate are essentially engaged in a high-stakes game of chicken. The rising Greek politician Alexis Tsipras of leftist party Syriza — which, depending on the day, is leading in the polls — has effectively campaigned on an anti-austerity platform by telling Greeks that if elected he will renegotiate more favorable terms for the country while securing its membership in the eurozone.

Greek leader of Coalition of the Radical Left party (Syriza) Alexis Tsipras on Tuesday, May 8, 2012. Photo: AP Photo/Kostas Tsironis, pool

For Tsipras, it is in Europe’s best interest to renegotiate more favorable terms than to risk a disorderly default and exit, which could wreak havoc for other vulnerable countries like Spain and Italy. He underscored this point earlier this week, when he told Germany’s Der Spiegel that, “If our country exits the eurozone, all of Europe is in danger.”

European leaders, however, have not been receptive to Tsipras’ bluff-calling strategy. Rather, they have made it clear that continued membership in the monetary union and further financial support is contingent upon Greek compliance with previously negotiated austerity agreements.

“There is no way of changing the commitments taken by Greece and also by the other 16 euro area member states,” said European Commission president José Manuel Barroso at a press conference last month. He added that, “It will not improve the situation of Greece or the euro area in general if the message is that we do not stick to our commitments.”

There was more tough talk from the IMF managing director Christine Lagarde over the weekend, when she told The Guardian newspaper that there is no possibility of the IMF renegotiating Greece’s austerity package. She also alluded to the widespread tax evasion in the country by adding that,“ [Greeks] should also help themselves collectively… by paying their tax.”

The end game

Given the hardball rhetoric, all eyes are on the June 17 election. If the Brussels-based bureaucrats, or “eurocrats,” are to be believed, should anti-bailout, anti-austerity proponents prevail, a Grexit will soon follow.

But others like former IMF chief economist Simon Johnson argue that even if the pro-bailout parties hold on to power this month, Greece has a slim chance of staying in the monetary union over the long haul. He notes that:

While the so-called “pro-bailout” forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens. It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers — either because they can’t pay or because they expect soon to be able to pay in cheap drachma.

France’s newly elected Socialist president Francois Hollande, along with Italian and Spanish leaders, has issued renewed calls for eurobonds, or mutually secured loans, as a way of bringing down borrowing costs for peripheral European countries. In effect, richer northern countries like Germany would subsidize the borrowing costs for its less competitive southern neighbors.

German Chancellor Angela Merkel at the World Economic Forum Annual Meeting in 2011. Photo: World Economic Forum

Not surprisingly, Germany is none too keen on this idea. Chancellor Merkel and members of the country’s powerful Bundesbank strongly oppose the idea of German taxpayers underwriting other countries’ debt, especially in the absence of any common tax collection and expenditure policy within the monetary union, and in the case of Greece, long overdue structural reforms in areas of labor, tax and retirement.

And therein lies the rub: Increased federalism is the only way forward if the euro is to survive. But the European project, borne of the post-war desire to facilitate peace on a war-torn continent, has become synonymous with economic hardship and political division for many citizens in member countries. Therefore, there is currently little appetite on the part of the governed to sacrifice their national sovereignty for “more Europe.”

There is also the question of timing. Greater fiscal and political integration would require time to enact sweeping treaty changes — time that leaders simply don’t have, especially now that market uncertainty regarding Greece’s standing is already having “contagion” effects on other embattled countries like Spain, which is currently staving off a banking collapse and battling rising borrowing costs. The World Bank recently underscored the contagion risk when it warned that Spain and Italy could be next in line should Greece depart the eurozone.

Then there are the unintended consequences of the brinksmanship that is being waged by European policymakers. Last week, the Financial Times’ Gillian Tett reported on risk managers hedging their bets against a euro collapse by implementing “asset-liability matching.” In plain English, this means that banks are increasingly making lending decisions on a country-by-country basis, rather than treating all eurozone member states as equals.

Tett writes, “While pundits engage in an abstract debate about a possible break-up, fracture has already arrived for many banks’ risk management departments.” She adds that “this fracture undoes most of the good created by the eurozone.”

Seen in this light, the upcoming Greek election and a possible Grexit seem beside the point, especially if far-reaching market repercussions continue to outpace the politics of the crisis.

It goes without saying that the unraveling of the world’s second largest reserve currency has the potential to unleash chaos in the financial markets. As for the U.S., a collapsing eurozone remains one of the biggest threats to our nascent economic recovery, especially if such an event were to spur a systemic credit crunch like the one that followed the collapse of investment bank Lehman Brothers in 2008. But the real tragedy of a euro breakup would be political undoing of the European project, which has been largely successful in facilitating peace and cooperation across borders, but now risks fracturing along national and regional lines once again.