With Hollande having won the French Presidential election, and fringe parties in Greece picking up a sizeable chunk of votes in the Hellenic poll, financial markets’ knee-jerk reaction was not encouraging yesterday. Fears that one or more of these may trigger a shift in European policy – and, in particular, away from austerity – have been cited as a key concern.
In truth, the situation in France is less troubling than some of the rhetoric would suggest. Yes, President Hollande has spoken about a (reasonably modest) increase in government spending. But he has also outlined revenue measures that, while not completely offsetting higher spending, demonstrate that he is not unaware of the fiscal situation. He has promised to balance the budget within a year of Sarkozy’s plan – hardly a large macroeconomic difference.
Hollande’s other refrain has also garnered support from other quarters. Growth is important. Even if a wealthy economy manages to get its deficit down, if it fails to grow then the accumulated stock of debt can still weigh on investors’ minds. Italy is a case in point – its deficit will probably be not far off 2% of GDP this year, better than ‘sound’ countries such as Austria and the Netherlands. But, without growth, the country could struggle to manage its large stock of outstanding debt. Tweaking the balance between growth and austerity just a little – for instance by pushing out deficit targets a bit, and recalibrating where spending cuts fall (so as to do least economic damage) is well within most of Europe’s grasp. Voters can feel appeased while deficits come down more slowly.
The bigger question probably lies with Greece. The failure of the Greek political parties to form a coalition government could see repeat elections next month. And there is the real possibility that an administration that arises from a June poll could choose to break the terms of the bailout deal agreed with Europe and the IMF.
What would be the consequences of such a move? In particular, leaving aside the obvious financial market turmoil and knock-on impact on sovereign spreads, what would happen to Greece?
First, and most obviously, Greece would go bust in spectacular fashion. This would not be the orderly sovereign restructuring that we saw earlier this year. If a new Greek government chose to break the terms of the bailout, then the next tranche of funds from its partners would not arrive. Within a month, the new government would run out of money and be unable to pay its pension, salary and debt commitments.
Given the previous restructuring, this would probably mean private sector institutions writing down their Greek bond holdings to zero – that is, writing off the debt altogether, leaving holes in their balance sheets. However, as a result of the past and current bailout Greece now owes a lot of money to official lenders in the form of its European neighbours and the IMF – and, as the likes of Argentina have discovered, they do not tend to write off debts. If Greece ever wants or needs help or access from these institutions in the future, at some point it will have to reach an agreement on repaying these debts.
So Greece would (properly) go bankrupt, causing widespread economic damage. One way to think of bankruptcy is to imagine running a balanced budget straight away. Further cuts to public sector wages, social security and pensions would be imposed immediately. Imagine four years of austerity crammed in all at once. The economic damage would be huge – and any recovery from it would depend on the flexibility of Greek labour and credit markets.
This leads into a second question: could a bankrupt Greece stay in the euro? Other euro area countries, via the Commission, may seek to impose fines or even sanctions on Greece if it broke the terms of the deal. But the ECB would hold the trump card. If it decided to withdraw its liquidity support for Greek banks – not impossible, if relations broke down completely – then the Greek banking sector would go bust. Apart from further market chaos, electronic payment systems could stop working, stifling all activity. Imagine if your credit and debit cards stop working today – how would you cope?
Faced with this, Greece would probably have to leave the euro, and by extension the EU. The practical means of creating a new currency would be less problematic than the legal hangover. The new currency would probably drop sharply in value, aiding the eventual recovery of the economy, but key questions would be the extent to which external demand actually then supported growth (would Germans still holiday in Crete?) and how easily Greek workers could shift between jobs and sectors in order to benefit. I, for one, suspect that economic rigidities would amplify the economic damage. Leaving the euro is not an easy option, by any means. But many Greek voters may not understand that.
There would be a huge question mark over the remaining euro member states as well. But the sight of Greece leaving the euro, and the carnage that would ensue, would probably stiffen resolve in the likes of Spain and Portugal to cut deficits, and in the likes of Germany to avoid a repeat performance. Ultimately, the Greeks could find themselves suffering further distress and poverty as the rest of Europe finally gets its act together. And many in Athens would think that really unfair.