Think Greece is better off ditching the euro? Read this first

She’s made her mind up.
She’s made her mind up.
Image: Reuters/Yannis Behrakis
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On paper, Greece’s referendum on Sunday (July 5) is narrowly focused on accepting or rejecting a proposal made by creditors to extend the country’s bailout deal last week. But leaders from the rest of the euro zone are pitching the vote in much starker terms: Greeks are effectively voting on whether they want to stay in the euro zone or not.

The mechanics of a so-called “Grexit” are murky, but if Greeks vote “no” in the referendum it becomes a real possibility. Off goes the fiscal straightjacket that comes with euro membership and in comes a freer hand for Athens to determine its own affairs. What’s the problem?

Economic heavyweights have been having their say. Paul Krugman says Greeks should reject creditors’ demands in the referendum (paywall), breaking from the “endless austerity” that comes with the status quo. After all, “much and perhaps most of the feared chaos from Grexit has already happened,” he wrote. Joseph Stiglitz is of a similar mind.

Nonsense, says George Papaconstantinou, a former Greek finance minister. For their many faults, the bailout deals that propped up the Greek economy over the past five years at least avoided “the meltdown we are seeing today,” he wrote in retort to Krugman’s comments (paywall). The country is “sliding towards totalitarianism,” he added for good measure.

Behind the scenes of this war of words, analysts have been thinking through the real implications of a Grexit, given the rising probability that it might actually happen. Standard & Poor’s reckons that there is a 50% probability that Greece will leave the euro zone, and has published a new analysis of what it would mean for the economy.

It makes for sobering reading. The new drachma would immediately drop by around 40% in value versus the euro, making euro-denominated debts an even bigger burden for borrowers. That spells trouble for banks, which are already straining under capital controls and wholly reliant on emergency support from the European Central Bank.

“Greece’s payment system would shut down and its banks would not be able to operate,” S&P says. This would also complicate trade deals, making it hard for Greek exporters to take advantage of the cheaper currency.

The economic shock and lack of investment would impose “a permanent loss in potential output” for Greece, the agency adds. That is, the country would never regain its pre-crisis growth path. Two years from now, the Greek economy would shrink by 25% from its current level. Recall that the economy is already a quarter smaller than it was in 2007:

And what about the rest of the euro zone? A Greek exit would dent GDP in Germany, France, and Italy by only around 0.2% or 0.3% within a year, S&P says. The reintroduction of a “currency risk premium” to the previously inviolable euro zone would push up borrowing costs, saddling the remaining 18 euro-member governments with €30 billion ($33 billion) in extra funding costs. This is a big, but manageable, bill.

But what makes sense on paper may not translate into practice. A country exiting the euro zone is truly uncharted territory, and raises existential questions about the viability of European institutions. “Grexit would be such a unique event that we cannot discount a scenario that could bring severe contagion and long-term damage to political cohesiveness,” S&P adds. “The environment could become less predictable, legal disputes could proliferate, and the fundamental commitment to the single currency could be called into question, exacerbating an already fragile economic situation in the region.”