Daniel W. Drezner

The 64 trillion euro question…

While I was on the road last week, I see that Greek elections managed to accomplish two things: 1)  A requirement for yet more Greek elections; and 2)  A recognition among European banking officials that this time, Greece might actually be leaving the eurozone.  Sooo … what happens then? The Financial Times has a useful ...

While I was on the road last week, I see that Greek elections managed to accomplish two things:

1)  A requirement for yet more Greek elections; and

2)  A recognition among European banking officials that this time, Greece might actually be leaving the eurozone. 

Sooo … what happens then? The Financial Times has a useful article that asks the appropriate big questions while providing some useful information.  Particularly interesting is the emerging belief that the eurozone now has erected the necessary firewalls to prevent contagion from Greece to the rest of the southern Med and Ireland: 

[W]ith a new, permanent €500bn rescue fund backed by the strength of an international treaty with multiple tools to buy sovereign bonds on the open market and inject capital into eurozone banks, some officials believe the contagion could be contained — much as it was after Athens finally defaulted on private bondholders last month.

"Two years ago a Greek exit would have been catastrophic on the scale of Lehman Brothers,” says a senior EU official involved in discussions about Greece’s future. “Even a year ago, it would have been extremely risky in terms of contagion and chain reaction in the banking system. Two years on, we’re better prepared."

The new eurozone firewall — now backed with additional resources for the IMF — is not the only reason some officials are becoming increasingly sanguine about losing Greece. Spain and Italy, they say, have taken huge steps to put their economic houses in order, enabling them to bounce back quickly if credit markets suddenly dry up and their banks wobble.

Still, uncertainty over how Europe’s banks would be affected has continued to be the primary concern.

Paul Krugman is somewhat more pessimistic. Sketching out the possible endgame, he posits that Spanish and Italian banks would experience massive capital flight, triggering the key decision faced by Germany:

4a. Germany has a choice. Accept huge indirect public claims on Italy and Spain, plus a drastic revision of strategy — basically, to give Spain in particular any hope you need both guarantees on its debt to hold borrowing costs down and a higher eurozone inflation target to make relative price adjustment possible; or:

4b. End of the euro.

And we’re talking about months, not years, for this to play out.

Krugman has been predicting Greece’s exit from the euro for some time now, but in this case I do think he’s correct about the choice posed by Germany — as yet more signals accrue about Merkel’s declining political strength. 

Now, actually, I suspect that Greece stays in the eurozone for longer than anyone suspects.  That said, based on my two empirical observations during the past two years — namely, eurogoggles and the Merkel Algorithm.  Here is how I would game out the "Grexit" scenario: 

1.  Greece’s departure is announced at the same time as an EU summit announces a boost to its new rescue fund and modest pro-growth German policies.  Markets initially react to this news favorably.

2.  Within 48 hours, negative news about the Spanish and Italian economies, combined with a second wave of stories revealing that the rescue fund isn’t as big as anyone thought it was, rattles financial markets and triggers the behavior described by Krugman. 

3.  The ECB does nothing, calling on Merkel European political leaders to take "decisive action." 

4.  After a week or two of agnonizing non-action, Germany announces half-measures that end the immediate panic gut set up Spain for more stagnation and a new crisis in 2013. 

Am I missing anything? 

 Twitter: @dandrezner

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