Testing euro exit scenarios
London-based think tank Policy Exchange is now judging the entries to the Wolfson Economics Prize, which asked entrants to propose the best way for a country to leave the eurozone. Following the relatively mild impact of Greece’s default earlier this month, James Barty asks whether the eurozone can survive in its current form
The good news is that the default of Greece, which had been so long in the making, in the end passed off about as quietly as could possibly have been imagined. The European Central Bank (ECB) and others were sufficiently worried about the fallout from the default that they expended considerable energy trying to ensure credit default swaps (CDSs) were not triggered. I never believed this was a sensible approach, as many institutions were using CDSs to hedge their bond exposure, and the only alternative to hedging was to sell the bonds.
In the end, the use of retrospective collective action clauses by the Greek government to ensure participation in the bond exchange ensured CDSs were triggered. Hopefully the fact that financial markets have shrugged off the default will encourage eurozone authorities to ditch this approach in any further restructuring that might happen.
But just because the Greek default has passed off quietly and the new loan package is in place does not mean the eurozone is out of the woods. Greece still has a huge mountain to climb. The reduction in the debt-to-GDP ratio that the default was undertaken to achieve is still dependent on further austerity measures and a recovery in the Greek economy. Many think this is unachievable, and that all the effort to put another rescue package in place for Greece is a waste of time.
Some commentators, including economist Nouriel Roubini, have suggested Greece should now leave the eurozone and devalue, in addition to the default. That is certainly not the policy of the Greek government, nor does it seem popular with the Greek public. But that might yet change if the latest round of measures proves unsuccessful.
Would an exit work? Roubini has cited the example of Argentina as a country that has successfully devalued, defaulted and recovered. Yet, as we argued in a recent report comparing Argentina and Greece, Argentina’s recovery was more a function of the global commodity boom than anything to do with its default and devaluation. Indeed, because it imposed its default on investors, it is still locked out of financial markets more than a decade later. Neither Greece nor any other member of the eurozone that might leave is likely to be the beneficiary of such a favourable tailwind to override such problems.
Those that cite exits from the European exchange rate mechanism also miss a key point. Those devaluations took place against a backdrop of the countries already having their own currencies, with their debt denominated in that currency and a subsequent strong global recovery. As a result, while there was effectively a devaluation of the government debt, there was no formal default. Any exit from the euro must encompass a default because investors bought euro-denominated debt. What would those countries do in respect of their obligations to the ECB and the remaining euro countries?