Let’s be frank: we are all guessing right now when we project the future of the high-stakes negotiations between Greece and the rest of Europe. My crystal ball blew a fuse and completely failed to predict that Prime Minister Tsipras would call a referendum in Greece for next Sunday, requesting support for rejection of the current European proposals. Judging by the commentary, it caught virtually everyone else by surprise, too. This is both an illustration of the difficulty of predictions in this fraught situation and is a game changer in its own right that makes the immediate future even murkier. Yet the larger fundamentals have not changed, so this is a good time to review what we can reasonably know and what is simply unknowable at this point.
Politics and the negotiations
We know that there is a middle ground to which the Greeks and their European creditors could move which would allow all the relevant governments to claim at least partial victory. The broad outline of such a deal has been visible for months and the proposals of both Greece and its European creditors are already in an area that could be accepted by the other side under the right circumstances. It therefore remains quite likely — although far from certain — that the two sides will eventually find reluctant agreement, albeit with considerable further economic and political pain possible before they get there. Greece’s banks are closed this week, and ATM withdrawals limited to 60 euros a day, which will hurt the economy and provide a foretaste of the pain that will grow the longer an agreement is postponed.
We know that the broad majority of the Greeks want the country to stay in the Eurozone while also gaining significant changes to the austerity and structural reforms previously agreed with the Europeans. The problem is that these two desires are at least somewhat contradictory, given what Greece’s European partners are demanding in exchange for the financial support that is likely necessary to enable Greece to stay in the currency zone.
We do not know how the referendum will come out. Many market analysts outside of Greece are predicting a “yes” to the European offer, based on the interpretation of previous polls that show strong support for keeping the euro “at all costs.” However, this ignores: (a) the conflict between the voters’ desire for the euro and their strong wish for an end to austerity; (b) the unreliability of polls in such unsettled circumstances; (c) the ability of events over this week to change views considerably; and (d) the fact that the exact wording of referendum or poll questions can swing voting results by 10 or 20 percentage points and the Greek government determined the wording. In the end, we just do not know how people will vote.
According to the Financial Times, the wording will be as follows. It will be a “yes” or “no” question and the box for “no” is placed above that for “yes”, which one might call leading the witness:
‘Should the draft agreement submitted by the EC, ECB, IMF at the Eurogroup on June 25 which consists of two parts that make up their full proposal be accepted? The first document is titled ‘Reforms for the completion of the current program and beyond’ and the second ‘Preliminary debt sustainability analysis’
Note that there is no mention of the euro, other than in the name “Eurogroup,” since that might lead people to vote yes to protect the euro, which the government wishes to avoid. Instead, there are all these acronyms of organizations that will not sound friendly to Greek ears.
We do not even know what Prime Minister Tsipras wants, which matters because it will help determine how he plays out the next week and succeeding months. He could plausibly have called the referendum for one of more of a number of quite different reasons.
One, he could have believed that the added pressure on Europe would bring forth an improved deal for which he could then campaign for acceptance. This tactic arguably may already be working as the Europeans have come back with an explanation of the counter-offer that they would supposedly have made to the Greek government on Saturday if the referendum had not been called. There is still room for further “clarifications” that would make this more attractive to Greek voters.
Two, he could be willing to accept the European deal, but needed to publicly oppose it in order to hold the support of the left wing of his very leftist party. A “yes” vote in the referendum would allow him to accept the deal without seeming to betray his party’s ideology or campaign pledges from January. Three, he could truly desire to reject this deal and is appealing to the voters to strengthen his ability to do so.
We do not know what Tsipras will do if he loses the referendum. The prime minister could call new elections, which Syriza would likely win once again, quite possibly with a larger share of the seats. Syriza is clearly still the most popular party and has gained kudos for “standing up for Greece,” despite concerns that the government has played the negotiations too tough, or even unskillfully. The Greek system gives an extra 50 seats in parliament to the single largest party, which will very likely be Syriza, probably enabling them to form the next government. This change would leave Greece in limbo while the election campaigning took place. Afterwards it could produce a further period of stalemate in the European negotiations or it could empower the re-elected Syriza government to reach a new deal if an imaginative way could be found to allow both sides to claim victory.
Alternatively, the prime minister could hold the government together and go back to the negotiating table and agree on a deal with the Europeans, based on the express will of the people to accept something similar to what is already on the table. It is unclear whether he would be weakened by the electoral rebuff or strengthened by the ability to “stand up for Greece” while accepting the people’s will for a compromise. The vote would presumably reduce pressures from his left wing for awhile, in any event. Another possibility is that Tsipras brings in a national unity government to implement the voters’ will. The latter seems less likely to me, except as an interim step towards a new election.
We do not know whether there will be a Greek exit from the Euro, given all these other uncertainties. It still seems unlikely, but there is perhaps a one in four or one in five chance it could happen.
The economic impact of continued conflict
We know that the rest of Europe will feel some of the pain induced by all the uncertainties, but at a much reduced level compared to what Greece will suffer. Business and consumer confidence will be damaged, stock markets will decline at least modestly, and interest rates in the other European countries that are perceived as relatively weak, such as Portugal and Spain, will likely rise in comparison to German rates as money flows to “safe havens.” So far today this has indeed been the market reaction, with core European stock markets down about 3 percent and peripheral markets down further. As for bonds, peripheral sovereign yields are up about a quarter of a percentage point or less, while Germany and other core European markets are seeing yields declining by a tenth of a percentage point or so. In brief, markets are viewing this development as bad news, but not horrible news.
There will be spillovers into the rest of the world, including America, although none of them are likely to be serious in the context of our overall economies. Ironically, the American economy may be pulled down slightly and the European economy helped by a fall in the value of the euro versus the dollar. (It has fallen about 1 percent so far today as of 8am.) Our stock markets may suffer as well, to some extent, from greater fears about the world economy as the European motor faces the risk of sputtering a bit at the same time as China is already slowing down from previous rapid growth levels.
We almost certainly know that if Greece does fall out of the Euro, its economy will initially go into sharp recession. The transition would be very ugly as businesses and consumers pull back aggressively in response to a huge increase in uncertainty.
We do not know how much more strongly markets would react if Greece actually does exit the euro. Markets are pricing in a probability that a deal will eventually be reached, which still seems the most likely scenario. The effect of a full Greek exit would likely be a multiple of what we are seeing from the weekend’s news, but would still probably fall into the “bad news” bucket rather than the “horrible news” one. There are two fundamental reasons for my belief. First, it is worth underscoring that Greece is simply not that big — it is only 2 percent of the overall European economy. Second, European authorities, especially the European Central Bank, will intervene heavily to counter the negative effects on the rest of the Eurozone from a Greek disaster. Further, the contagion risks are not daunting in the short term because nobody expects that Portugal or Spain or Italy is on the brink of creating their own version of the Greek crisis. They all want to stay in the Eurozone and the remaining debates about austerity and structural reform are less pressing in those countries, partly because their economies are mostly growing again. The risks are in the longer-term, if a future situation arises where a weak Eurozone country may be tempted to leave. At that point, markets will have to react to the demonstrated possibility of a Eurozone exit.
We do not know what the long-term effects on Greece would be of exiting the Eurozone. I believe it will be worse off in the long run outside the Euro, but the effects beyond the initial adjustment period are open to debate and there are those who think Greece would eventually be better off. A major reason I disagree with them is that they tend to implicitly assume that the Greeks would adopt all the right monetary and fiscal policies once they are on their own, which I doubt strongly. First, it’s too difficult a feat for anyone; critical mistakes will be made. Second, there is no particular reason to expect a Syriza government to manage the economy well, nor have the parties previously in power gained my confidence. Greece has a somewhat dysfunctional political system and exit from the Euro will not magically cure this.