The full article of A. Koutras:

Today’s Situation

The Greek state has gone bust after years of financial mismanagement, corruption and nepotism that created a state economy of soviet proportions. The European partners rushed to Greece’s help and gave loans albeit with strict conditionality. However, they made these loans to the people and the parties that were responsible for the mess in the first place. It was like West Germany giving money to Eric Honecker in order to disband his Stasi, restructure East Germany and prepare it for unification. As it happens the people objected to this idea. Unfortunately, this objection took the form of refusing the European help and path. In other words many identify Europe and in particular Germany as the culprit.

Populist politicians are not a rare species in Greek politics. In fact they form the overwhelming majority. The lack of rational debate that was promoted by most political parties finally paid off. No-one can easily discern fantasy from reality. Conspiracy theories have displaced common sense. Many voters wanting to punish the politicians responsible for this and possibly their own selves for voting for them all these years cast their vote to the suicidal left and extreme right (including fascists). Europe responded to this with a simple proposition “Either in with our terms or out”.

The bluff hypothesis

A basic objection that one hears often against the European position is that Europe is bluffing. There is no way that Greece can be kicked out or that Greece would leave the Euro. Let us see if this is true. Those who play games like poker know well the concept of a bluff. The same bluff cannot be performed by more than 1-2 players. Europe and Eurozone is not one player but 17 (in the case of Eurozone). To think that 10 or more of these countries, European commissioners, ministers and other politicians have agreed to bluff is a conspiracy theory. Three years now and the same players have not managed to solve a problem that represents 2% of the European GDP. Did by magic agree to bluff? Reality is somewhat different.

The constant vacillations of Greece have exposed the weaknesses of the economy and the gap between Greece and Europe in the areas of political rationality and discourse, social structure and culture. European policy makers are beginning to discern that the main problem in Greece is not financial in essence. The crisis is Greece was not a result of the world credit crunch or of bad lending practices by the banks. This was not clear to most Europeans when they signed the first bailout and MOU. The degree of total mess the Greek state was in was not known nor the corruption at all levels of the state apparatus. Now however, things are different. Slowly, a consensus opinion is formed that argues that it is time to put a backstop on the losses and instead concentrate in saving Spain. At least Spain conforms with most of the dictates and does not have second thoughts on the European future. It is not coincidental that we frequently hear of good wishes when it comes to Greece. Everyone is wishing for Greece to stay in Europe. It is like the priest giving the last rites to a terminally ill patient. In other words a new dynamic seems to be shaping that wants Greece outside Europe.

But it is not just the “bad Europeans” that want this outcome. Many in Greece wish for the same outcome. Some, for ideological reasons, others because they naively believe that they would make money in the process. Many, because they see political gains or the chance to govern and others because of obscure personal reasons. There is no conspiracy. Some are dressing their opinion in nationalist paranoia and others in socialist or communist terms. There are always the ones that simply want to see their debts reduced. The beloved dear uncle is dying and relatives, wives, mistresses and servants rush to the house to get the wall paintings and the silverware while others are trying to influence the will.

The exit cost

A frequent argument against kicking Greece out is that it is going to cost the other European countries huge amounts of money. Here, we need to clarify few points. The Treaties do not allow for kicking a member out. Article 7 only mentions suspension of parts of the treaty and only if there is a breach of article 2 which basically refers to democracy, human rights, equality etc.

Thus assuming that Greece does not degenerate to this level it can only ask to leave the EE or the Eurozone. How much would this cost. I am sure many policy makers and countries have done this paper exercise. Most calculations would be probably be wrong but need to start somewhere. Let’s give a brief look at some numbers:

• The Hellenic Republic has around 65billion of bonds outstanding under English law. The current market price is around 20% or 13billion. Thus if Greece declares a moratorium the maximum loss would not exceed 13billion, assuming that bondholders have marked to market their holdings.
• The IMF and EU loans would be around 240billion in nominal terms (including the money allocated for Greek banks). It would be prudent not to annoy the IMF so let us assume that Greece keeps servicing the IMF but imposes a moratorium on interest rate payments to the rest. As these loans carry an average coupon of around 3% the losses would be 7-8billion a year. These loans do not need to be repaid till 2022-2042 anyway. Moreover, all of these loans are under non-Greek law (English), and this means that when and if Greece decides to rejoin the European family these would have to be settled somehow. For example the Greek revolutionary loan of 1825 was finally settled in 1930, a mere 105 years later. The PSI in this respect is a double edged sword.
• ECB. The ECB that was exempted from the PSI still owns around 50billion of Greek debt. We do not know the terms of these bonds or where they are marked by the ECB as the swap was done in secret. However we can conservatively assume that 50billion losses are on the cards. The EU however, can use the special account that was created to keep on servicing these bonds directly and simply add the cost to the amount the Greeks owe to Europe.
• Then there is Target2. The obligations of the Bank of Greece towards the Eurosystem. These are estimated at around 130billion. It is not known how a breakup can be implemented. Could it be that the ECB provides some help to the reborn BoG to settle this and pay in the next 50y? Who knows?

The truth is that on a nominal basis the total loss would be north of 400billion but when one looks at the immediate losses then these are very manageable by the rest of Europe. The question is, how much would Europe save by stopping payments to Greece versus the money to keep Greece in the intensive care. How many more Eurogroup meetings would have to be done and how much political capital would be thrown on the Greek problem. This is a much harder calculation and any guesses are welcome. Would Europe simply postpone the inevitable for Greece at the risk of a much higher bang later? These are some of the enigmas that European policy makers are asked to solve. Greece has many wounds and not all are healed by throwing money.

The conclusion is that the exit cost is high but not unbearable. In any case, it is not politicians who are going to pay but the taxpayers of the remaining member states. If European taxpayers buy the argument then the probabilities of a Greek exit increase. Recent polls show an increasing trend in this direction.

The contagion cost

The third and perhaps more serious objection against a Greek exit is the danger that there may be a contagion, a metastasis of the crisis to other peripheral countries like Spain. Many argue that this is going to be the end of the United Europe. Europe would break up, Germany would lose and finally capitalism would be defeated by the socialist forces. The truth is that if Greece had left 2 years ago the tremors would have been significantly stronger. Now, and after a successful PSI (remains to be seen whose success it is) there is no danger of a financial or banking collapse. Parties have done their war exercises and simulations and we are told that they are prepared for some of the worst contingencies.

However, there is always the political and social risk. In reality the market is pricing correctly the financial implications of a Greek exit but has no way of estimating the risk of metastasis in Spain or other European country. Are these two events correlated? In other words, if tomorrow Greece decides to do everything that the Troika demands and stays in the Euro would the Spanish zombie banks come back to life? Would there be a rush to buy Spanish properties? Probably not. Maybe, this is why France and Germany are trying to raise a firewall. Hollande’s victory might speed up this process.

Talk of growth is just political crumps. European states must find ways to reduce their debts and deficits and in many cases do the structural changes (similar to those that are demanded in Greece) before they proceed with money printing. The challenge of the politicians is on how to sell this policy. Here lies the real danger for Greece. If Greece continues the ambivalent policies towards Europe, then Europe might decide to save Spain and do a catharsis with Greece. In other words Greece would be the catalyst that is going to propel Europe to a faster federal union but is not going to take part in it.

It is certainly true that the probabilities of an EU breakup are higher than they were 5y ago but most who opine it are doing it in bad faith rather than rational argument. United Europe took a long time to form and was the dream of many for generations. The union has made many mistakes but it is a living organism that evolves and adapts. In the process some countries may drop out while others may be at a disadvantage, but the main idea would survive.

Legal exit parameters

Until the Lisbon treaty there were no provisions for a member’s exit. Article 50 introduced such a possibility. However, article 50 only refers to an exit from the union and not from the monetary union. As it is natural, legal opinion is divided. There are those who believe that an exit can happen only if Greece uses this process to get out of Europe and then tries to re-enter with a special status like Britain. Others are of the opinion of a selective suspension of articles related to the monetary union.

In both cases, it seems the legal and mental jumps are great and Europe would have to structure procedures on the go. Both procedures are also time consuming. For example the first one needs 72% majority (minimum 65% of population) and the consent of the European parliament. In the end any obstacles would be cleared politically rather than legally and details would be filled on the fly. History does not offer many examples. The traditional empires or federations (if we can call Europe as such) do not easily allow members to flee. Many times the centrifugal or secessionist forces are crushed with force. We do not think that this is realistic in our case. The example of the Soviet Union is not similar as there was a massive breakup.

The selective suspension of articles has also some interesting complications but at least spares Greece the negotiations for re-entry (article 48). A danger in this case is that the right to selectively suspend some articles may be extended to other chapters and other countries.

The choice of a unilateral exit by Greece would be the most problematic and dangerous as Greece would breach the treaties.

However, by far the biggest hurdle is how Europe and Greece would react from the time of the exit announcement to the final exit. This may take few weeks or more likely months.

New Greek Drachma

There are many technical problems that make the reappearance of the New Greek Drachma (or whatever the new name is going to be) problematic. Most of the problems though are Greek and not European.

History has many examples of currency changes but most if not all deal with the demise of an old currency and the introduction of a new one. In other words the old currency stops being a legal tender and to be accepted as a means of exchange. As such the incentive of currency holders is to give up the old for the new no matter how low the value is. States recognize the sovereign right of a country to issue a currency and determine the exchange rate (Lex Monetae). In the case of the Euro things are different. The Euro would still exist and most probably would be a stronger currency than the NGRD. Also according to protocol 24 (3^rd stage of EMU) that sovereign right was taken away and pooled together with the other countries to create the Euro. Putting these details on the side a possible sequence of actions and events could be (The actions are highly speculative and hypothetical)

• The Hellenic Republic passes a law giving the BoG the right to issue NGD, to conduct monetary policy, to oversee Greek banks and to provide liquidity in the new currency. In addition it freezes banking transactions in order to change the Euros of all Greek citizens into NGRD. The original exchange rate does not matter at all whether it is 1 to 1 or 1 Euro to 100NGRD. It is a nominal exchange. What matter is what you can buy with it.
• Another law forces redenomination of all liabilities and contracts made under Greek law to NGRD.
• As it is highly unlikely that paper notes would be ready in time, Greece might decide to stamp or otherwise cancel the paper Euro already in the banks with 100Euro Cancel-100NGRD. This may need the consent of the ECB as the notes are liabilities of the ECB. NCB are allowed to print notes according to their quota and the notes are distinguished by the first letter in front of the numbers. For example Greece has Y while Germany has X and Spain V. This however, cannot be used as a criterion since banknotes circulate across Europe. We can assume that electronic transfers would begin faster than the paper money as it only involves changing computer code.
• What is going to happen to the Greek banks? Their bonds if issued under Greek law would redenominate while those under English law most probably would not. The same goes for Greek corporates. For other contracts and derivatives it gets more complicated.
• Collateral given to the ECB would no longer be valid although in anticipation of such a move Greek banks would have requested funding from the ELA mechanism which is the liability of the Greek state. This would then be converted to the NGRD. Thus an early warning sign could be a massive increase in the ELA (currently at 54billion).
• The BoG would no longer be a Eurosystem member and ECB should return the capital plus any reserves (including gold) that the BoG contributed originally. However, the BoG would have a massive liability towards the Eurosystem through the Target2 imbalances. Would the other NCB’s accept the loss? Who decides any disputes?

In conclusion if Greece decides to change the Euro into NGRD it would encounter many problems. Anyone having Euros outside the banking system would hoard them and anyone having Euros inside the banking system would try to take them out causing a bank run. In no way this is a smooth changeover. Black market would thrive and almost certainly there would be controls on the movement of capital and foreign exchange and price controls. For a considerable period absurdity would rule and there is a real danger of a failed state. It is conceivable that enhanced security measure would be introduced to safeguard public and state enterprises, banks and other assets. The biggest losers would be public servants, pensioners and salaried workers that have not hoarded Euros or other hard assets. The example of Argentina where bank safe deposits were opened and the dollars found were converted might be replicated.

The abovementioned actions are highly hypothetical and speculative. For the changeover to the NGRD to be successful Greece needs social calmness, planning and organization. These are hardly qualities that characterize the Greek state. In addition, many of the actions described, if they happen, breach fundamental rules and values of the EU. In other words, it is possible that article 7 and 2 (mentioned earlier) might be used to suspend Greece. Again this is a possibility but chances are that Europe would help Greece overcome some of the hurdles in the changeover.

GreekEconomy

If Greece crosses the transitional period successfully then the economic pros and cons would not take long to manifest. Obviously, the devaluation shock would be good for Greek exports and tourism. The abrupt reduction in wage cost if it is accompanied by structural reforms and opening of the economy would most probably be beneficial and the economy would jumpstart very fast. If FDI is encouraged by tax, and labor laws then the possibility of averting hyperinflation is realistic. Greece would need to find hard currency to pay for energy (current account balance is -19billion) and Europe and the IMF would help there.

The bad scenario is if Greece decides to go autistic and closes up in which case the probabilities of a failed state increase. The rapid reduction in the GDP would not be reversed and Greece might degenerate fast. Traditionally, immigration acted as a safety valve (witness the millions of Greek diaspora) and we will probably see this again.

Conclusion

The possibility of Greece exiting the Euro and introducing NGRD is neither impossible nor highly improbable. Whether this would mean catastrophe depends on how the state and the people are going to handle the changeover, especially after they lost a significant part of their wealth. It is my conviction that Greece should fight to stay in the Euro and try to avoid the adventure of introducing a new currency by force. Exiting the Euro is a very expensive very volatile and very dangerous way of a state reducing its liabilities (salaries, pensions etc) as most of the loans are not under its jurisdiction and cannot be reduced to zero with a simple law (like the PSI). In any case the structural changes in the economy would have to be done, Euro or NGRD.

The eleven-member National Council (ESET) is the top consulting body in Greece dedicated to research issues and to their creative links to technology. The General Secretariat of Research and Technology (GSRT) provides administrative support to ESET, and the latter advises directly the Minister of Education, Continuing Education, and Religious Affairs, as well as the Committee of Ministers on Research-Technology-Innovation to be formed following introduction of the new law on research.

ESET, with the administrative help of GSRT and scientific input from high-level, international thematic councils, has recently completed the first phase of the funding program “Aristeia I” (“Excellence I”) to the tune of 62m Euro, and it has now issued a call of proposals for the second phase (60m Euro) that also includes special provisions for support of young researchers.

The proposals approved for funding in the first stage of the Program, Aristeia I, are expected to contribute to advances in knowledge that are significant by international standards. Funding limitations prevented the funding of all highly promising projects and researchers, at least in the first stage of Aristeia. ESET is looking forward to submission of new innovative proposals in the second stage, but also to the resubmission of improved proposals that could not be funded in the first stage. The call for proposals for Aristeia II is to be found here.

The next key project for future growth, already launched by ESET, is the preparation of a national framework plan for research, technology, and innovation (ESPEK), with 2014 to 2020 as the horizon. After completion of open consultation, ESET is currently in close contact and collaboration with the TES (sectoral scientific councils), aimed at identifying priorities in the sciences, social sciences, and art and humanities to be incorporated in ESPEK.

We publish here a presentation (in Greek) of the work and the philosophy of ESET written by its Chairman, Prof. Stamatis Krimigis. This presentation was made some time ago, in February 2012, to the Hellenic-American Medical Association, and we publish it in order to illustrate the effort in this potentially important area for future growth.

More detailed information on the activities of ESET can be found on its web site.

The political debate, even as we are entering one of the most important elections in the country’s recent history, has largely avoided the key question of how to genuinely reform the tax system, procurement in public works and the military, education, health care, product market competition and the justice system. The recent ‘haircut’ applied to part of the public debt is by no means a substitute for reforms – in fact such measures should be viewed as operating strictly complementary with reforms. Thus, whereas a credible plan for fiscal and political stability is a necessary condition for turning the economy around, a number of specific reform initiatives also need to be urgently undertaken. These refer to different areas of the economy, but a connecting thread for all of them is the need to support or re-build institutions that have been abused and to set up new rules.

Despite a popular (or rather ‘populist’?) belief, Greece’s problems did not start two years ago with the IMF-EU-ECB intervention. This was the outcome, not the cause. The twin deficits of the Greek economy, from a fiscal and a competitiveness viewpoint, have been built gradually during at least a couple of decades. Their common source has been the mode of operation of the political system and in particular how partisan objectives and related special interests have been interrelated with the functioning of the economy, both in the public and the private sectors. Is there hope? Only to the extent that – by facing the prospect of an uncontrolled bankruptcy – the political powers are forced to redefine their relation with the economy, we can have a real end to the crisis.  As the potential of the Greek economy is huge, and has been much suppressed, a fast and genuine convergence to the core of the euro-zone economies is very likely to be initiated in such a case.

The Greek Universities in the last few decades have generally operated well below the level where they could and should be.  The blame for this should fall mainly on the State which has treated universities essentially as subsidiaries of the Education Ministry rather than as independent and accountable education and research units.  The governance structure allowed partisan student groups to play a dominant role, often supported by and supporting faculty members who were unable or unwilling to produce academic work.

The new law, adapted a few months ago by a very large parliamentary majority is certainly not perfect. However, it fixes many of the problems of the old regime and offers reasons for hope: it makes the election of the key university administrators no longer dependent on the partisan student groups; it allows for more independence; further, each unit will be accountable and subject to formal evaluation; and it facilitates the interaction with universities and academics from abroad. In fact, this law was one of the very few examples during the current crisis of an attempted structural reform, and not simply another example of legislation implemented fiscal austerity.

It was fully expected that the partisan students and other parties whose interests are harmed groups are reacting to the new law. It is a bit more surprising that parts of the political system, even if they have nominally supported this law, are now not supporting its implementation, and are instead hiding behind the violent actions of small groups. This is quite unfortunate: Greece cannot exit the current deep crisis simply by doing less of what has been doing in the last decades – it has to be reformed, in a genuinely progressive direction.  Improving the quality of the education system has to be one of the key starting points, not only for the impact it can have on economic growth but also as a way to alleviate social inequalities.

See http://www.stern.nyu.edu/networks/NET_radio_economides_1_03172012.mp3 and http://www.stern.nyu.edu/networks/NET_radio_economides_2_03172012.mp3

The full article of M. Makris:

Eurozone (EZ) countries formally approved on Wednesday 14^th of March a second, €130-billion, bailout for Greece that will keep the Greek government funded until 2014. This “historic agreement” came amidst many voices from academics and policy think tanks arguing that Greece may be better off by exiting EZ and regaining control of its (new) national currency. In fact, the debt crisis in EZ has given rise to a debate over the advantages and disadvantages of a monetary union membership, especially for countries such as Greece, Portugal and others.

This debate is not new. In the years leading to the institution of the European Monetary Union (EMU) there had been a heated debate on the pros and cons of a country entering a monetary union. This debate will almost certainly resurface in the run-up to the forthcoming elections in Greece.

The basic economic arguments in favour of entering EMU are:

Adopting the Euro will make it easier for businesses and consumers to compare relative price levels across member countries. That is, being part of EMU would increase price transparency. This will facilitate intra-union trade and increase the competitive pressures across member countries and markets. As this will lead to lower prices, entering EMU will potentially have gains in terms of consumer welfare.

A related argument comes from the fact that joining the Euro will reduce exchange rate uncertainty, and lead to lower transactions costs for companies and tourists. 
Membership of Euro can thus have a further boost in consumer welfare, directly through lower costs, or indirectly through higher corporate profits and hence paid dividends and corporate tax revenues. Reduced exchange rate uncertainty and transaction costs will also lead to increased trade flows. This will further stimulate competition in markets for goods and financial services.

The potential gains from lower transaction costs were estimated in 1990 by the European Commission at around 0.1-1 percent of EU GDP, with the actual savings varying with the size of the countries.

Estimations of the gains in terms of increased trade flows vary. However, even conservative estimates point to significant trade gains. For instance, research in 2001 by T.Persson and co-authors, which that corrects downwards earlier work by A.Rose and (joint work with) J.A.Frankel, find 60% trade gains in the long run from joining EZ. Under a 2002 estimation by Frankel and Rose that 1 percent increase in total trade (as a share of GDP) raises per capita income by 1⁄3 of 1 percent, we thus have that adoption of Euro could potentially raise GDP in the long run by 20 percent. The UK government estimated also in 2003 that if UK were to join EMU, and certain flexibility and sustainability requirements were met, it “could enjoy a significant boost in trade with the euro area of up to 50 percent over 30 years and that UK national income could rise over a 30-year period by between 5 and 9 percent.” Even after restricting attention to short-run gains and of materialised gains by EZ members so far, Euro adoption could raise GDP by 2 percent over 20 years.

The increase in competitiveness by joining the Euro will also increase businesses’ incentives to innovate and invest in R&D. Higher investment will enhance productivity. Higher competitive pressures due to increased trade flows could also help to promote supply-side reforms in member countries and encourage specialisation, which will further increase productivity.

By removing currency barriers to trade, a country potentially faces improved access to foreign funding. Thus, EMU could also facilitate investment flows within the EZ.

Membership of a single currency area increases also the competition for inward investment both from within and outside the EZ. Such competitive pressures will further increase the scope for supply-side reforms and, in particular, for enhancing the flexibility of labour markets. The reason is that flexible labour markets are highly effective in attracting foreign direct investment. In a study by the UK Department of Trade and Industry of primary data, generated from a questionnaire distributed to 1800 trans-national companies, all of whom possess existing production facilities in the UK economy, it was found that “labour market flexibility identified as representing moderate or high degree of importance by 60 per cent of respondents.”

An increase in inward investment and the enlargement of markets will also imply an increase in the productivity of labour. Thus, EMU membership will also lead to higher wages and employment, and hence to long-term benefits for households.

Taking this broader (and harder to quantify) range of benefits into account, recent studies that focus on Central European countries, specifically on Hungary and Poland, find that adopting the Euro could add 0.3–0.9 percentage points to average GDP growth for 20 years.

In a monetary union, inflation is the responsibility of an over-arching central bank – the European Central Bank (ECB) for the case of EMU. Because of this, monetary policy may not always follow narrow national interests. In this way inflation is insulated from national politics and electoral cycles. This delegation of monetary policy will thus enhance price stability and maintain interest rates at low levels, and hence further boost investment. These effects have been more than obvious for countries such as Greece and Italy. For instance, the nominal interest rate on 10-year Greek government bonds dropped from around 20 per cent in 1994 (when it was announced by the government that Greece will aim at entering EZ in 2001) to less than 3.5 per cent in early 2005. Inflation, which averaged almost ten per cent in the decade prior to EMU entry, was only 3.4 per cent on average over the period 2001 through 2008.

However, economic reality is often much more complicated and unpredictable. For instance, politics play a central role on the kind, if any, of reforms that a nation adopts. Interest groups such as labour unions may be strong enough to block reforms that run against their interests. Existing institutions and bureaucracy could also hinder the administration of policies, and prove to be an important obstacle for inward investments. Consumers and national governments may abuse the availability of loans at low interest rates. Banks, in the face of competitive pressures, may adopt practices that involve excessive risks. Recessions occur, and can hit countries differently depending on the flexibility of existing institutions and the sector-specifics of economic downturns. These are not arguments against EMU membership per se. Rather, they are reasons why materialisation of benefits can delay, and why countries might need to delay entering EZ until their economy has been adjusted and prepared for entry. They are also reasons for increasing fiscal cooperation within EMU, and harmonising tax and pension systems.

For many experts, a combination of the above factors has been the main contributor for the debt crisis in EZ. What is interesting, however, is that this crisis has also brought up some (new) arguments for why exiting a monetary union can be very problematic, especially in times of economic distress. We outline these arguments with reference to a Greek exit, though many of them apply also for other EMU member countries such as Ireland, Italy, Spain and Portugal.

To start with, exiting EMU would have an irrecoverable damage on the credibility of the eurozone. A pre-requisite for the achievement of currency certainty we have discussed above is that markets perceive the exchange rates between member countries as permanently fixed. Having a country exiting the EZ would mean in effect that exchange rates within EMU are not permanent, with profound consequences for price transparency, levels of exchange rate uncertainty and transaction costs, and thereby for trade flows and competitiveness across EZ.

Another major damage of Greece exiting EMU would be to the credibility of the bailout process. Markets would start questioning the ability/resolve of eurozone politicians to manage the Portuguese, Irish, not to mention the Spanish and Italian crises. The bailouts of Portugal (€78bn in May 2011) and Ireland (€85bn in November 2010) were designed to assist both countries until they could borrow in the markets again, just as with Greece. Investors may thus question whether the same solution will work for the other bailout recipients. The borrowing cost of these countries will skyrocket to the levels Greece has been experiencing for the last two years, making a default by these countries a foregone conclusion.

If Greece reintroduces the drachma, everyone in EZ could be affected. Any unilateral exit from EMU would prompt panic in other EMU countries that are in trouble. Citizens in countries such as Ireland could easily assume that their governments might follow suit, with negative consequences for consumers’ confidence in keeping their money domestically.

A new drachma would devalue to such an extent (more than 50% according to some experts) that the Greek debt liability (around €260bn after the recent “haircut” of 105bn Euros) would explode, given that Greek debt is denominated in Euros. In all certainty, this will lead to a default on Greece’s public debt, which will cost the Greek banks around €30bn (taking into account the recent “haircut” of 50% on average).

The chain reaction will be profound. The ECB will have lost around 150 billion Euros (because of money owed by the Greek banks and the Greek bonds that ECB has purchased since May 2010). EZ member countries will have to recapitalise the ECB. There will also be a very high risk of a domino effect onto Eurozone’s banks, as they own a big share of the Greek debt as well as of (private) debt issued by others who have lent to the Greek government. According to figures from the Bank for International Settlements, when you add in other forms of Greek debt, such as lending to private banks, pre-haircut exposure of private banks amounts to $14.6bn for the UK, $34bn for Germany and $56.7bn for France. Even after taking into account of a “haircut” of 60% on average, it is clear that a domino effect will give rise to additional debt problems in EMU and additional pressures for propping up private banks across EZ. Economic activity will plummet across EMU and by implication the European Union (EU). Countries across EU will face an unprecedented recession, with countries such as Germany and UK hit the hardest due to their high volumes of trade  (around 40% of trade) with (other) EZ countries.

In addition, the remaining currency union will be left with a Euro whose value will skyrocket, propelled by the collapsing exiting economies and an ensuing currency war. This will lead to a massive drop in the exports of Germany and its remaining partners, and a further dip in economic activity.

To make things worse, a Greek exit could increase free-riding behaviour within EMU, as other countries might perceive that it is possible to run excessively expansionary policies and subsequently exit the currency union to devalue their debt.

The above effects on EU and EMU countries of Greece exiting EMU in the current economic environment lie, in fact, behind the two bailouts of total value of €240bn offered to Greece to date. They also lie behind voices within Greece that urge for a return to drachma, hoping that such a threat will force Germany and other “like-minded” countries that push for strict austerity measures to accept bigger losses for their banks and taxpayers, and support alternative measures such as the introduction of a Eurobond.

Preventing similar “hold-up” problems in the future by EZ member countries can explain the hard stance many fiscally disciplined EMU members have adopted against Greece. However, another reason for this could also be that a threat of Greece exiting EMU may be “empty” because of the catastrophic consequences such decision will also have for Greece.

Following an exit from EMU, there would be a significant increase in exchange rate uncertainty vis-à-vis the eurozone, which would imply a loss of inward investment funds and hence a significant decrease in wages and employment. Reintroducing the drachma would also have negative implications for price transparency. Competition and productivity-enhancing investment would thus suffer.  Long run inflation rate would once again be under the control of domestic politicians (as it was prior to joining the Euro) and hence prone to electoral incentives. Indicative of this is that the Greek inflation rate was over 20% in late 1980’s, following overly expansionary monetary (and fiscal) policies prior to national elections.

Capital controls would have to be introduced to prevent the movement of Euros outside Greece in the run up to re-introducing the drachma currency. This would call into question the country’s EU membership itself and the loss of all the socio-politico-economic benefits that come with such membership. Benefits that are well accepted even by countries who doubt the desirability of EMU.

Greek politics have been marked by a drive to bring the country closer to Western Europe than Eastern Mediterranean. Therefore, exiting the Eurozone and not being at the core of European integration would be seen as a political suicide.  Greece would loose its status as a major investor in Balkans and Eastern Europe, and hence as an important actor in this volatile region. For example,12% of foreign direct investment in FYROM in the period 1997-2009 was Greek, while Greek investments in Serbia, Bulgaria and Romania total at around €6bn. Accordingly, factoring in the geo-political characteristics of Greece and their interaction with its neighbours’ EU membership should be enough to send shivers down the spine of Greeks.

As we have already mentioned, exiting EMU would almost certainly be followed by a default, which would also be catastrophic for the Greeks themselves. A default would cut off rescue loans from the EU and IMF to the Greek government, and from the ECB to the Greek banks. The key observation here is that the Greek government has consistently been earning less in tax revenues than spending (even after excluding debt payments). As a result, the Greek government would be unable to pay for basic functions of the state (though Greece’s primary deficit has been decreasing lately following the austerity measures of the last two years – currently being at around 2% of GDP). This would bring about more revenue-raising measures, and a further massive blow to domestic activity.

More importantly, the Greek government, having no access to external funds, would have no money to rescue Greek banks. The economic upheaval by a bank run (or rather the prevention of it by banning withdrawals and freezing banking accounts) on exiting EZ would be devastating. The collapse of the banking sector coupled with the shutting down of basic state operations would push the country’s economy even deeper into recession. Tax coffins would drain and spending on benefits would plummet bringing even more despair to the less fortunate economic groups in Greece.

To make things worse, Greece’s current account deficit, which measures the trade deficit, is currently around 10% of GDP. That is, Greeks spend around 10% more than what they earn from selling their own products abroad, and all this despite the spending cuts in the last two years. This is a symptom of low competitiveness, which as we have hinted earlier is a result of a badly organized domestic bureaucracy, very strong unions and interest groups. In fact, in the period 2001 – 2009, competitiveness declined by around 20-25% (with the lower number corresponding to a measure by consumer prices, and the higher number to a measure by unit labour costs). A current deficit requires an economy as a whole to attract an equivalent amount in financial investments from abroad. Such investments take mainly the form of lending. Crucially, most of the Greek current account deficit consists of imports of basic goods that are not produced domestically and of necessary inputs for domestic production such as fuel, chemicals and machinery. Therefore, having no access to external funds would paralyse the country in the short run.

And this onerous situation would continue for as long as the much needed supply-side reforms do not take place, unless the Greek government allows the (new) drachma to plummet vis-à-vis other currencies in an attempt to regain competitiveness and eliminate its current account deficit. Nevertheless, though this might seem an attractive option, it would be an extremely painful one.

Import prices and inflation will skyrocket. An example of what may happen comes from the 2008 banking and currency crisis in Iceland. The Icelandic krona lost around 40% of its value in one summer. Interest rates reached 15%, and inflation climbed at 14%, very quickly. In fact, many economists do expect a rapid devaluation of the new drachma of at least 50%. Living standards would be hit hard, as Greeks would be rushing to spend their drachmas before their value erodes further due to subsequent devaluations and increases in the inflation rate.

Of course some could argue that these short-run costs will soon be outweighed by the increase in competitiveness, the attraction of foreign investment and the return to positive growth rates. However, modern Greece is mainly a service economy: agriculture accounts for 3.6% of GDP, industry for 18% and services for 78.3% (2011 est.), The main sector that would benefit from an episode of severe devaluation would be the tourism industry that accounts for roughly 20% of GDP. But there are limits to how much the tourism industry can expand and absorb, especially in the face of similar incentives on the part of Portugal and Spain, and fierce competition by other Mediterranean countries. Unless the necessary reorganisation of the Greek state takes place and labour markets become more flexible, it is hard to argue that Greece has any credibility in terms of attracting foreign investment.

I have argued that the economic effects of Greece exiting EMU will be devastating both for Greeks themselves and their European partners. However, paradoxically, it is the nature of these effects that makes a quick solution to the debt crisis in the Eurozone very difficult. One – unfortunate – reason is that a divide between North and South Euro members seems to have emerged with each side trying to avoid bearing the biggest part of the costs that are needed to resolve the crisis. Another reason is the complexity of the situation with various proposed solutions often having counteracting effects on different dimensions of the problem. In any case, I do hope that Europe comes out stronger from this crisis.