What will happen when Greece leaves the Eurozone?15 May, 2012, 5:08. Posted by Zarathustra
Tags: Euro Crisis
So it is now becoming more likely that Greece will leave the Eurozone at some point, probably in a very near future, after the Greek election produced no viable government. Paul Krugman even brought up the final scene of Wagner’s Götterdämmerung, where everything burnt up in the universe (well, the universe of Der Ring des Nibelungen anyway).
For a while, I have been saying that a Greek exit should be unavoidable. The design of the Eurozone in its current form is flawed that, as many have said, the only two ways out would be a full fiscal union or a break up. By fiscal union, I basically mean that those in better financial position would simply have to give money away, and to basically say that the so called fiscal compact or whatever rules in the Treaty that said all country should run balanced budgets are rubbish. Try telling Germans about that, I am sure they will not be happy with that. Politically, this is just not very probable after all, and we are left with the option of Greece leaving the Euro.
The next question then, to many people, is what will happen next. There are many different people having different opinions on capital control and bank runs, how the European banking system will blow up next, or how much the New Drachma will fall vis-a-vis the Euro (on New Drachma, it is quite obvious that it will depreciate, following the post-default experience of Argerntina, for example). For some dreadful scenario, John Hempton has some excellent historical perspective.
While the destiny of the New Drachma appears more clear, I have doubts about the Euro. FT Alphaville has a nice summary of what all those FX strategists are thinking. In short, most are rather bearish on the outlook of the Euro. But then, I am just not so sure. Europe, like the rest of the world, has high level of debt, and debt deflation is a nasty business. With debt deflation, falling asset prices forces borrowers to sell assets to repay the debts (or else they will be in bankruptcy). In that situation, demand for currency is high, and with loans being repaid (or turning bad) at a faster rate than new credit, broad money supply will fall unless the central bank is aggressive enough to offset the money being destroyed in the banking system. In that scenario, paradoxically, Euro could actually be strong. Macrowonders have another theory of why Euro could still be a strong currency (or indeed, even stronger) due to positive real rates.
And then, there is another question of what impact it will have to the rest of the world. Surely it is not going to look pretty, consider that trade will probably collapse and capital will flow away from the rest of the world back into Europe. Will it be something like the bankruptcy of Lehman Brothers? Or will it be the bankruptcy of Creditanstalt which triggered to more lethal stage of the Great Depression of 1930s? Perhaps.
But after all, are we actually kidding ourselves if we are to hold any firm opinion on what’s going to happen? We are basically in an uncharted territory with regard to the breakup of the Eurozone. We just don’t know what’s going to happen except that isn’t going to look pretty.