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Greek voters yesterday overwhelmingly rejected further tax increases and spending cuts in a referendum on austerity measures demanded by Greece's international creditors. While the "no" vote greatly strengthens the Greek government's position domestically, it essentially has no value outside the country. It makes any future compromise between the government and creditors difficult to reach.
The difference in the response from the technocratic European Commission, which took "note of and respects the result of the referendum in Greece," and the political Eurogroup, whose president also took note of the outcome of the Greek referendum, but then went on to add that "this result is very regrettable for the future of Greece," is telling.
The rest of the euro area is extremely unlikely to extend any material reform concessions to Prime Minister Alexis Tsipras as a result of this referendum. Whatever additional fiscal leniency Greece may gain going forward will be directly related to the far worse starting point of the Greek economy. Financially, everyone in the euro area knows most of the approximately €341 billion (3.4 percent of euro area GDP1) lent to Greece either directly or through the European System of Central Banks (ESCB) is lost. Indeed, the International Monetary Fund (IMF) recently noted that even before Greek banks were closed a haircut of up to 30 percent on euro area Greek debt would be needed. With the Greek economy now on the brink of collapse, that number will have grown to much more than 30 percent.
In other words, no matter what happens next, Syriza has already turned most of the euro area's exposure to Greece into sunk costs. Financially, the euro area has nothing much to salvage in Greece and therefore has even less reason to compromise. Doubling their recovery rate from Greek exposures from 10 to 20 percent is not something Francois Hollande, Matteo Renzi, or Angela Merkel are going to bend over backwards to achieve. Tsipras and Syriza don't seem to have understood that by undermining the Greek economy they have not only increased the amount of new measures they have to undertake to reach even lower fiscal targets but also lowered the benefit to anyone from striking a bargain with them.
Greece's only real option now is for Tsipras to use his new political dominance to perform a political somersault. He will need to build a national unity government and strike a deal in line with the Troika's existing conditionality to earn the genuine interest of creditors and then exploit the division among them to get the euro area to accept something close to the IMF's offer of 30 percent debt relief. This will be a very, very tall order, as it would essentially mean that the referendum and bank shutdown in Greece have been for nothing—apart from solidifying Tsipras' domestic political position. Tsipras must bring new and credible economic proposals with him to the Euro Summit tomorrow in Brussels. As my colleague C. Fred Bergsten put it to me today: "He will be trying to become a hero by solving the great mess he has created himself!"
What happens next? It seems highly improbable that the European Central Bank (ECB) will agree to any increase in emergency liquidity assistance (ELA) to Greek banks without a firm political commitment from the euro area to very quickly reach agreement with the Greek government. Without such assistance, Greek banks will remain closed and slide ever closer into bankruptcy. The earliest the ECB could act to ease the liquidity pressure and cash crunch at the Greek banks would be Wednesday, following tomorrow night's Euro Summit. However, for the reasons listed above, unless Tsipras brings new proposals with him, any early breakthrough remains extremely unlikely and the Greek banks thus are likely to remain shut. Indeed, in light of the deterioration of the Greek economy the ECB could choose to signal its intent to increase the haircuts on collateral posted by Greek banks for the existing emergency liquidity assistance. This could accelerate the Greek banking sector's collapse, unless the euro area—like in 2011—issues a fiscal guarantee for parts of the Greek collateral posted.
The Greek government has a series of smaller bond market redemptions in the coming weeks, but the critically important one is a €3.5 billion payment due to the ECB on July 20. Failure to make that payment—which would be impossible without new money from the euro area—would likely prompt the ECB to scale back ELA to Greek banks, thus making insolvency unavoidable. In that scenario, the Greek banks will remain shut for the foreseeable future, unless other domestic sources of capital are found. Greek bank depositors seem to be the only source. Significant depositor haircuts would likely be required for Greek banks to reopen in the short run. However, with most Greek deposits below the €100,000 protected threshold, this would mean the Greek government would either raid protected deposits (which would be strongly resisted by European authorities) or almost completely wipe out deposits above this level. Both cases spell further economic disaster for the Greek economy.
Until the referendum result, I would have called it insane to think that the Greek people would accept a government whose policies intentionally or not imposed the near suicidal economic costs of a complete banking collapse on them. Rationality and democracy would subsequently have ensured that a new government with saner policies was installed in Athens. However, one can no longer be sure that this is the case in Greece. It is thus unclear if a prolonged standoff between the Greek government and the euro area (and the associated inevitable collapse of the Greek banking system and dramatic further deterioration of the Greek economy) would result in a change of heart in Athens. The proud "no" from Greece may stand, even as its people grow dramatically poorer. Unless Tsipras changes course, ties between the EU and euro area institutions and Greece could sever for a protracted period.
Even if it continued to default on all its debts, the Greek government would surely be running a sizable primary deficit by now. Without further financial aid from the euro area, Syriza will very soon have to start paying its domestic claims to public workers and retirees in IOUs or other invented parallel currencies. Without access to additional euros, the government may also ultimately seek to recapitalize its banking system relying on such newly created vehicles.
I have discussed before that the Greek government would fail to introduce a new currency in Greece and therefore ultimately not really benefit from any real exchange rate depreciation effect and thus not see growth return. Of course, Athens can pass the prerequisite laws, forcefully recapitalize its banks, and redenominate remaining deposits into a new drachma; it may even be able to print and mint new notes and coins eventually. However, by the time such actions would be implemented, capital flight would have further devastated the Greek economy. And more importantly, would anyone believe a Syriza-led government's commitment to credible fiscal and economic policies to complement a new independent Greek monetary policy?
In this scenario it seems most likely that Greece remains officially euroized (i.e., uses the euro while outside the eurozone/European Union) and becomes another Montenegro—or perhaps merely unofficially very highly euroized, with Greeks continuing to hold the vast majority of their financial assets and conduct transactions in euros and only those without a choice relying on the new local currency. In the best case, Greece would eventually become a typical Latin American runaway inflation country of the early 1980s.
It is now up to Tsipras to avoid this outcome.
Note
1. €194.8 billion in direct bilateral or European Financial Stability Facility loans from the euro area and approximately €146.2 billion through the ESCB's Securities Markets Programme and other intra-Eurosystem liabilities. Data from Barclays.
