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Order from Chaos

How might Greece fall out of the eurozone?

The very difficult negotiations between Greece and its European funders have led many to speculate that Greece will, or should, pull out of the monetary union. (Often referred to as “Grexit”.) Greece would then regain control of its own exchange rate and interest rate policies. Generally this is combined with an assumption that Greece chooses to default or radically restructure its very large debt obligations to European nations and institutions, and possibly to the International Monetary Fund. Further, everyone assumes that there would be a major currency devaluation upon exit from the monetary union in order to make Greek goods and services more competitive in world markets, which would become important as external funding would likely dry up for some time.

Grexit would be a watershed event, with major implications for the Greek economy, its politics, and its geopolitical role, possibly pushing it still closer to Russia, for example. Further, Grexit would show that it is possible for troubled countries to exit the monetary union, with implications for the rest of Europe, especially in the troubled periphery. In addition to economic impacts, such as higher interest rates, there could be a profound effect on politics within Spain, Ireland, Italy, and even France. Relations within the European Union (EU) would certainly be affected as well, possibly leading to tighter integration, but potentially creating greater disharmony instead, depending on unpredictable circumstances.

I believe that the probability of Grexit is low, on the order of 5-10 percent, and the consensus of financial markets seems to be in this same range, although there are certainly analysts and investors who see a much greater likelihood. However, it is worth exploring how Grexit might happen, particularly since there are many misconceptions on this score.

The main point to understand is that Grexit, if it happens, is likely to be undertaken very reluctantly and in stages. Greece would begin paying some of its bills in a new promissory note that would become a quasi-currency and it would institute capital controls, but with the hopes that all these steps could be reversed once negotiations produced a result that allowed the nation to remain in the monetary union. The bulk of this paper will explore the details of this staged exit.

The second key point is that there is necessarily a great deal of guesswork about how Grexit would occur. The founders of the monetary union deliberately burned their bridges behind them to make it as painful and unlikely as possible for any nation to pull back out. They had seen previous currency arrangements, such as the “Exchange Rate Mechanism” of the 1980’s and early 1990’s, effectively collapse as one or more nations lost the will or ability to do what was necessary to stay in. They were determined to leave no back door through with a country could leave. 

Thus, there is no legal mechanism to pull out of the monetary union, except if Greece chose to withdraw from the EU altogether. There are mechanisms for voluntary departure from the EU, but they would be cumbersome, long, and extremely painful for Greece. (It may be worth emphasizing that there is no mechanism in the treaties for involuntary withdrawal, since commentators sometimes suggest kicking Greece out.) Even if it could be achieved easily, Greece benefits enormously from being in the EU and would lose far more than it gains by pulling out. It receives very substantial EU aid every year and Greece’s ability to veto EU actions is one of its strongest international negotiating chips. Further, it would have to negotiate new trading arrangements with its former fellow members at a time when most of them would be very annoyed with Greece, which could seriously harm its large trade with other EU nations. Beyond this, there are also valuable privileges that would be put at risk, such as the ability of Greek citizens to freely move within the EU.

In theory, the member states could design a new mechanism to allow Greece to depart, but this would be completely impractical in a crisis as it would be much too controversial for the swift agreement that would be necessary. 

Without a mechanism for withdrawal from the monetary union, Grexit would occur on an ad hoc basis, and we are left guessing what would happen. Unfortunately, history does not provide us much information about what to expect. We understand the impact of sharp devaluations, such as would accompany Grexit, since there have been many of those over time. We also have examples, such as Argentina, to show what happens when a country ties the value of its currency to another nation’s and then that tie breaks. But, withdrawal from a common currency has many additional elements, particularly the questions of which euros are automatically converted to the new currency and which debts are involuntarily redenominated. Greece could pass a law converting all euro debts of Greek households and entities into the new currency, and probably would. However, there are large external debts where the foreign party is unlikely to simply accept Greece’s decision, including substantial borrowings that are explicitly governed by English law, which would presumably not recognize the redenomination passed under Greek law. Similarly, it is unlikely that Greece’s European partners will simply accept repayment of their official debt in the new Greek currency on a one-to-one basis.

There are a few cases where currency unions have broken up, because a country has split apart, such as the Soviet Union or Czechoslovakia. However, the changing of the currency was intricately tied into the larger transformations, reducing the value of any lessons for the present case.

There appear to be two main scenarios. The most dramatic, and by far the least likely, would be for the Greek government to suddenly pull out of the monetary union and declare a new currency, usually referred to as a “drachma” after the previous currency, although in reality a new name would probably be chosen. All bank deposits, other assets, obligations, revenues, and payments would, by law, be redenominated in drachmas. Greece would need to do this very swiftly and by surprise, presumably over a weekend, in order to minimize capital flight from the country and deposit withdrawals from the banks. 

This straightforward approach is a very low probability outcome, because it would be effectively irreversible, would entail massive risks, would almost certainly initially result in a serious recession, and would not have broad political backing in Greece. Polls consistently show that the large majority of Greeks are willing to accept a great deal of sacrifice to stay in the monetary union. Consistent with this, Syriza campaigned on tough negotiations with the rest of Europe, but with a commitment to remain in the monetary union.

Therefore, if Grexit happens, it is likely to be a staged withdrawal, undertaken reluctantly. The first stage would begin with bank runs and capital flight, presumably triggered by a breakdown or impasse in the European negotiations that caused investors and depositors to fear that Grexit or debt defaults would occur. This could be accelerated by a decision by the European Central Bank (ECB) to cease allowing the Greek central bank to provide Emergency Liquidity Assistance (ELA) to Greek banks. ELA is a program that allows banks to borrow from their central bank using lower quality collateral than is normally accepted by the ECB. Greek banks have used up most of their higher quality collateral, so major deposit withdrawals without ELA availability would quickly render them illiquid, creating a banking crisis.

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The Greek government could shore up the banks by infusing them with more capital and liquidity by purchasing shares or subordinated bank debt, but this could quickly use up the state’s remaining reserves of euros. The next step would be to pay for the shares or debt with promissory notes, denominated in euros and bearing some low rate of interest. The intent would be to replace them with actual euros once the Greeks obtain a new funding agreement with their European counterparts. The banks themselves might then run out of euros to pay depositors and the government might have to decree that it was acceptable to pay a portion of withdrawals in these promissory notes. The government might have to start using promissory notes to make other payments, as it ran out of euros. These promissory notes would become a quasi-currency, but one which would undoubtedly trade in voluntary transactions at a very considerable discount, approximating the devaluation that might occur if full Grexit were to happen.

The government could attempt to avoid the need for promissory notes, or limit the requirement, by imposing capital controls on the withdrawal of euros from the country. This is an option available under the EU’s treaties in an emergency and was used in Cyprus starting in 2013. Capital controls, of course, do have substantial economic costs by strongly reducing the incentive for inward investment, interfering with trade, and creating legal and other uncertainties. (For example, some businesses may find themselves unable to pay all of their foreign obligations.) Such controls are also inevitably evaded to some extent, reducing their benefits.

Limitations could be placed on withdrawals of bank deposits in order to reduce the need for promissory notes and to limit capital flight, since much of that capital would have started out in a bank account. This would likely produce an even greater hit to the economy than capital controls, since it would freeze many transactions and severely reduce consumption by households and businesses.

It would be possible for this quasi-exit to remain in place for quite a long time, although the harm would mount over time. Short-term workarounds by households, businesses, and the government would run out, while the economic distortions would magnify. If the Greek government remained in power and was unable to achieve an acceptable deal with the rest of Europe that would allow the emergency measures to be rolled back, then it might reach the point where it appeared preferable to acknowledge the new reality and move to an actual exit from the euro. For example, there would be less pressure for economically damaging controls on capital movement or deposit withdrawals once the feared devaluation has already occurred.

There is less need for surprise if capital controls and deposit withdrawals limits are in place, but there would still be benefits in stealth Grexit. If people saw an exit coming with time to take action, they might move to more extreme, and possibly illegal, methods for getting their euros out of the country. After all, exit would almost certainly be done in conjunction with a sharp devaluation, meaning that a euro outside Greece would become worth much more than a former euro trapped in Greece and forcibly converted to a drachma.

Some argue that Greece would be better off in the long run outside of the monetary union, although I am unconvinced of this. Either way, there is little doubt that a withdrawal would trigger a severe recession, at least in the short-term until the uncertainties worked their way through the system. A fuller discussion of the short and long-term costs and benefits of Grexit is beyond the scope of this paper, however.

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