If Greece leaves the Euro

I have read so much stuff from well established economists who argue that the best solution for Greece would be to default, leave the Euro and devalue.  Some of those arguments can be found here as well as in the writings of Lombard Street Economics.

But much of this is pie in the sky stuff, which underestimates the impact of such a step for Greece. (Things are different for the rest of the Eurozone as I will discuss in another post).

The biggest holders of Greek Government bonds ("GGB"s) are of course the Greek banks, so any serious probability of a default combined with a withdrawal from the Euro would almost certainly a trigger a massive run of the Greek banks, with depositors seeking to transfer their savings to other Eurozone banks.

The combined impact of a run on the banks together with a sovereign default would almost bankrupt the banks. This would lead to a serious credit squeeze in the economy as one sector after another would collapse, raising unemployment and reducing output.

This is of course very different from the UK in 1992, the memory of which is seared into the collective conscious of London based economists. There withdrawal from the ERM was followed by a reducing in interest rates, credit growth and economic expansion.

Despite low Eurozone interest rates, Greece faces very high interest rates, with 2 year spreads over Bunds of over 40% pa at the time of writing, so in principle if withdrawing from the Euro would allow Greek interest rates to fall, this would be a positive development.

But how likely is that?

Greece's basic problem is that it has weak political institutions. Tax evasion is rife, corruption is said to be widespread and confidence among Greek's in their own Government is weak.  In these circumstances, the willingness of Greeks to hold drachmae would be low and this would almost led to a collapse in the currency, with a high risk of hyperinflation. You can see how any attempt to recapitalize the banks with dramchae might led to depositors withdrawing their deposits and exchanging them for Euros or dollars. To contain these risks, it is easy to see that interest rates may actually rise rather than fall from current levels. That is likely to squeeze the economy even further.

Even if Greece were able to stabilize itself in the short term (with EU or IMF support post Euro withdrawal), in the medium term it is hard to see how any savings would be retained in drachma, so business investment would either have to come through foreign currency borrowings in the form of Euros or dollars and that would make any further devaluations very costly for businesses. And no country in this position can run a current account deficit - which imply capital imports.

Much of this has been rehearsed before, for example in Mexico in 1994 or Indonesia in 1997. In Mexico part of the solution was to allow Mexican banks to offer dollar deposit accounts to local depositors and in both these cases as well as in Thailand, Russia, Argentina in the years that followed capital controls were imposed to limit capital inflows. But if Greece were to do this it would have to leave not only the Euro but also the EU - that is assuming it has the institutions to enforce capital controls.

The Greeks may be facing a bleak few years but its probably nothing compared with what they would face outside the Euro.