THE conventional wisdom that emerged immediately after Europe’s weekend elections that voters may have forced Europe into a new crisis reckoning seems to have been correct.
Greece is struggling to put together a government and whatever government eventually emerges will probably press for a renegotiation of its bail-out deal. Euro-zone officials are saying that this is out of the question.
Odds of a Greek departure from the euro zone appear to be rising sharply; Intrade now puts the chance of exit in 2012 at close to 40%, up from 22% a week ago. Markets are shuddering at the possibility; European equities are dropping like stones, yields around the periphery are jumping Spain’s 10-year yield is back above 6%and German yields are sinking to record lows. Big trouble is brewing.
The talk is increasingly turning to how Greece might fare upon leaving the euro-zone. Some are speculating that with Greece in the midst of a deepening depression and suffering from full-on capital flight, there is little risk to calling it quits. Indeed, if one is going to have an economic disaster, one might as well get a depreciation out of the bargain.
I suspect this analysis is wrong. Yes, a depreciation would boost the competitiveness of Greek exports, but I’m not sure that would matter much in the chaos following on an exit. Both people and capital would make a mad rush for the exits once it became clear that Greece would be leaving. In such circumstances, currencies typically overshoot on the way down. A plunging drachma would create intense inflationary pressure. That would no doubt be exacerbated by Greek funding needs; despite deep austerity it continues to run a large deficit and the temptation to fund it through printing will be strong. Hyperinflation would be a real possibility. The political dynamics of such turmoil are difficult to foresee, but one suspects that fringe parties would only benefit from chaos. As The Economist has warned, Greece might well become a failed state upon leaving the euro zone. It might not, of course, but I’d put more money on disaster than salvation.
I suspect matters would worsen for the euro zone, as well. Some now argue that exposure to Greece has been reduced sufficiently that the rest of the single-currency area could cut the country loose without too much financial trouble. That might be right. The question is whether this particular genie, once released, could be contained. The stakes of such a gamble would be enormous. If there were contagion, and if markets attacked Ireland, Portugal, and perhaps Spain and Italy, thinking that they could be next, the euro zone might be overwhelmed and driven into chaotic collapse. That’s far from a certainty. Whether shaky markets could handle just a rise in the probability of such an outcome is entirely unclear.
Europe has tolerated the discomfort of the past few years because the alternatives might possibly be far, far worse. But consistent failure to really address the crisis has steadily increased the temptation to roll the dice. Eventually, one party or another may decide the bet is worth the risk. And that is a frightening thought.