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Greece Turns from Drama to Tragedy



Prime Minister Alexis Tsipras's surprise call last week for a referendum on the austerity proposals by its international creditors, followed by the shuttering of Greece's banks and stock exchange on June 29, opens a dangerous new chapter of its crisis. It could also spell the end of Tsipras's political leadership. The prime minister's moves have inflicted lasting damage to the Greek economy. The most hopeful scenario from now on is that Greek voters reject his irresponsible call for a "no" vote on the referendum and approve a return to serious negotiations with the Troika of international creditors, returning Greece to the European fold.

The latest move was reported to have been instigated by a small faction of party leaders in the Syriza politburo. Not even the Greek government representatives in Brussels were aware of it in advance, having learned of it by Twitter late Friday night. By the end of the weekend, what appears to have been a desperate attempt to force Greece's creditors—the European Commission, European Central Bank (ECB), and the International Monetary Fund (IMF)—has backfired. Not only has the Eurogroup of finance ministers rejected the Greek government's plea for an extension of its emergency loan program, the European Central Bank has moved to cap—but not to eliminate altogether—its emergency lending for Greek banks, effectively forcing them to shut down to avoid more bank runs. In addition, the 18 other finance ministers in the euro area have declared that Greece had unilaterally left ongoing negotiations and hence ended prospects for an extension past June 30.

This latest doubling down by Tsipras exceeds what was previously predicted here. The calculation that Athens can end its program and expect other taxpayers in Europe to continue to pay its bills was never going to fly in European capitals.

Tsipras's claim that he merely wants to consult the Greek population in the spirit of democracy is absurd. No democratic legitimacy can be gained by putting a highly complex, unpublished, and indeed legally expired set of proposals before a Greek population lacking the information to make an informed decision. Greeks will inevitably be voting not on the issues in the referendum but on whether to let the country's banks and therefore its economy collapse, exiling Greece from Europe's economic institutions. Europe's political leaders, including those in France, Italy, and Germany, have already reinforced this view in their statements.

If Tsipras really were so devoted to democratic legitimacy, he could have called a referendum on very similar terms months ago, when there was ample time before the expiration of the current program. Germany and the euro area actually supported the idea earlier this year.

The ECB's move to maintain its level of emergency liquidity assistance  (ELA) rather than cutting off the program altogether was a shrewd political move and appropriately conciliatory for a technocratic institution, but this step left no uncertainty about the outcome. The decision by Greek authorities to close Greek banks until at least July 7 and limit access to deposits was a sensible response by Athens, averting a further bank run, bank insolvency, and ultimately the forceful closing of the Greek banks by the European banking supervisors in the single supervisory mechanism (SSM) granted last year to the ECB. Such a closure would have been permanent until Greek banks were restructured and recapitalized. A recapitalization of that kind could only come with assistance from the euro area. By pre-emptively closing their banks, the Greek authorities have at least maintained the possibility that they may reopen again before long.

The damage to the Greek economy from Tsipras' reckless actions is already immense. A ceiling of €60 a day on withdrawals will reduce economic activity, strangle the tourism season, and produce layoffs by cash-starved small businesses, on top of already high unemployment rates. The poor and elderly will suffer the most from the lack of access to cash or banking services, curbing their ability to pay essentials like rent, food, and medical expenses.

The Troika has meanwhile published details about the negotiations, making it clear its willingness to consider further Greek debt relief. That is the meaning of its statement that the discussions "would also have addressed future financing needs and the sustainability of the Greek debt." In other words, Tsipras' sudden decision to hold a referendum may also have short-circuited those prospects. The next Greek government will thus at least have a place to start negotiations.

The Prospects for the Referendum

The most likely outcome is that Greece, which for all its problems is wealthier than its neighbors, will avoid a gamble, focus on concern for the future, and approve the Troika measures, defying the recommendations of the Greek government.

Amid the market sell-off on Monday, the ECB signaled its intension on Saturday to prevent contagion that would set back economic recovery in the euro area, possibly intervening if there is a material sell-off in the bond markets of Spain, Portugal, and other economically troubled peripheral countries. The prospect of Greece failing to make the upcoming €1.6 billion payment to the IMF on June 30 does not mean it has no money to pay. For example, Greece could hypothetically find the money for the IMF by forgoing pension or wage payments.

Another alternative could materialize, in which the Eurogroup could itself make the IMF payment out of money that it made in profits from purchasing Greek bonds in 2010–13. These funds were supposed to have been transferred to Greece but were not because of Greece's refusal to accept Europe's conditions. The euro area would be well-advised to take this step, effectively paying Greece's bills to the IMF, avoiding a declaration of default before the referendum and signaling to the Fund that European leaders want to avoid the rest of the world suffering from Europe's inability to keep its house in order.

Should the referendum be approved, Tsipras's government is unlikely to survive. His declaration that he would sign an agreement with Greece's creditors if Greek voters give the OK is hardly likely to be accepted outside the country. The ECB and euro area are not likely to increase emergency lending, enabling banks to reopen, without regime change. Fears that the ongoing bank run would resume would be too high. Even though they have been closed by the Greek government, Greek banks can de facto only reopen with the acceptance of the ECB.

Approval of the referendum would therefore likely usher in new elections, which would also likely postpone the lifting of deposit controls by several more weeks, if not months. Only the immediate ouster of Tsipras and the formation of a new national unity government following the referendum would speed up that timetable.

What if the referendum is rejected, as Tsipras wants? The consequences would be severe and uncertain. European leaders are hardly likely to change their minds about their demands. There is nothing to suggest that the elected politicians of other euro area members would suddenly declare that the democratic will of the Greek people trumps that of their own electorates, which retain their equally valid democratic right to refuse to continue to pay for Greece's spending habits.

In addition, deposit controls will almost certainly not be lifted on July 7, as Tsipras has vowed. Without these controls, Greek banks would fail and probably be shut down permanently.

Without access to further financial assistance, the Greek government would swiftly default on its loans to European creditors and the IMF, at great cost to the rest of the euro area. Many in Greece—and in the Anglo-Saxon Keynesian blogosphere—would undoubtedly welcome such an outcome as "sticking it to Germany." But such knee-jerk sentiment is flawed. Germany's immediate loan exposure to Greece, after all, amounts to the German government's fiscal surpluses from 2014–17, so Germany could easily afford to absorb that amount.

Ask instead what the Italian government could have spent the €40 billion it has lent to Greece on, or the Spanish its €30 billion exposure. Perhaps they could have used the money to employ a million Italians and Spaniards, nearly as many euro area residents as the 1.2 million Greeks without jobs. Greece would be naïve also to think that, in the event of a default, it would retain access to subsidies or disbursements from the regular EU budget.

The Dangers and Difficulties of a New Drachma

If the European-imposed reforms are rejected by the Greek people, Greece's banking system will collapse and the country will lose the benefits of membership in the most economically and financially relevant European institutions. Much analysis assumes that Greece would then leave the euro area and adopt its own currency, the new drachma. The dangers and difficulties of such a step are gravely underestimated, however. The challenge of printing new money and avoiding counterfeiting would take months.

There are precedents for dissolving currency unions—the Soviet Union, Yugoslavia, or Czechoslovakia come to mind—but these examples are of limited relevance. This would not be a currency union dissolving but one country breaking away, introducing its own national currency, while the euro would continue to function more or less as before. A better analogy would be countries like Ecuador, Panama, and El Salvador, which have dollarized currencies and use the dollar as a currency substitute. No modern economy that has adopted the US dollar as a currency has ever tried to undo that decision and reintroduce its own currency. Equally, the concerns expressed by some that a "Grexit" would destroy the euro area are alarmist. No other euro area member is likely to try to emulate Greece's self-destructive behavior. Indeed, they are more likely to pursue greater, not lesser, integration, after experiencing the successes of being helped out of their earlier difficulties in 2010.

Because any new Greek currency would be backed solely by the credibility of Greek governing institutions, such a currency would lack what is known as a "store of value."1 Even if a new drachma circulates in Greece, Greek residents are certain to demand transactions in euros—if they are not barred legally from doing so.2 A rapid nominal Greek currency depreciation would inevitably result.

Being a relatively small economy, which imports many essentials (energy, food, medicine, etc.) and exports only a relatively limited number of often volatile items (tourism and shipping services), Greece has a more limited scope for import substitution compared to larger and more diversified economies.3 There would thus be a large passthrough from a declining nominal exchange rate to domestic inflation in Greece following the introduction of a new currency. Reducing Greece's real exchange rate by adopting a new currency will be difficult and inflationary. All told, a Greek attempt to implement a full Grexit by introducing a new currency is bound to fail to improve the economic outlook or even to displace the euro's role within Greece itself.

There is no such thing as a smooth transition to a new national currency. Greece would instead likely end up like Montenegro, which unilaterally euroized its economy in 2002. A Grexit is no solution for Greece, only a path to New Drachma purgatory (let's call it Grurgatory) and pain.


1. The store of value function of a currency is one of three key attributes. The other two are the functions of medium of exchange and unit of account. To successfully function as a store of value, a currency has to be capable of being predictably saved, stored, and retrieved for (roughly) the same value. In other words, any currency inflation affecting it must be kept within a certain range.

2. The Greek government might for instance pay wages or accept payments from residents only in a new currency or require that bank deposits covered by any deposit guarantee scheme in Greece be held in their new currency.

3. I am indebted to my colleague Avinash Persaud for making this characteristic of small island economies clear to me in relation to Greece.

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