How the Greek crisis is changing monetary union
No matter how the standoff between Greece and its creditors ends, it will reshape monetary union. A bad compromise would seriously undermine the position of the reformers in other crisis countries and ultimately legitimise excessively high budget deficits. By contrast, monetary union without Greece would likely be stronger in the long run, provided that a post-Grexit crisis were not so dramatic that the ECB had to activate its OMT purchase programme – a situation which we do not envisage. Either the next few days will see a tainted compromise with Greece (see p.2), or Greece will leave the monetary union. The outcome of the crisis will affect the shape of monetary union in the longer term. This would not be immediately perceptible, but in due time it would be clear that a change of course had set in.
Scenario 1: Poor compromise would be a step closer to a transfer union In the first instance, consider the possibility that Greece reaches a compromise with its creditors: The new Greek government’s main objection to the current aid package is the austerity conditions attached to it. These involve Greece raising its primary surplus (i.e. budget balance excluding debt interest payments) to 4½% of GDP next year. An agreement seems highly unlikely unless this stipulation is substantially relaxed. The Greek government has already proposed a reduction of the target to 1½% of GDP, something which has often been openly discussed as a possible compromise.
However, this would also mean abandoning the target of a balancing the overall Greek budget, unless interest rates on bailout loans (already very low) were slashed even further or generous debt relief were approved. Moreover, it would not be feasible to ask other countries (who would have to support Greece financially) to accept the imposition of measures on themselves which are deemed unreasonable for Greece. A primary surplus of 1½ % would thus become the upper limit of budget consolidation required under the stability pact. Using this figure as a benchmark, the deficit of some countries would, even with interest rates at current lows, already be close to or even above 3% of GDP (see chart 1). An economic slump or a rise in interest rates would finally make this threshold a nonsense. And the balanced budgets envisaged under the fiscal pact would be forgotten. Countries such as France and Italy would undoubtedly welcome the final demise of the stability and growth pact, and the markets probably react well to a fiscal policy seemingly geared towards growth.
However, this would put paid to a serious reduction of debt-to-GDP ratios within the euro zone. As a result, sustainable government financing would be further undermined, and in the long term pressure would increase on the ECB to reduce the debt burden by means of a lax CHART 1: With a primary surplus at 1½%, budget deficits would often tend to remain high General government budget deficit on the condition that a primary surplus of 1½% of GDP is achieved and with interest outlays at their current levels, in per cent of GDP monetary policy and higher inflation, which would simply pass on the burden to all the euro zone countries. This would effectively mean that the euro zone had finally morphed into a transfer union.
Scenario 2: Grexit would strengthen monetary union … A better outcome for the euro zone than a dodgy compromise with Greece would actually be for Greece to leave monetary union. Grexit would after all show the opponents of reform in the euro zone which way the wind was blowing. The Spanish government, for example, under pressure from the left-wing Podemos party in the run-up to this year’s general election, would be on a stronger footing. It could thus argue that, if Podemos turned out victorious, Spain might have to exit the monetary union as Greece did in this scenario, running the risk of sliding into economic chaos. Grexit would invalidate the notion of Emu being permanent. Yield premiums on government bonds could again respond more to what was happening in the individual member countries, which would no doubt enhance incentives for a solid fiscal policy and structural reforms. … unless exaggerated response forced ECB to intervene … In the longer term, though, Grexit would only strengthen monetary union if it did not stun the financial markets so much that the ECB felt compelled to activate its OMT bond purchase programme.
If it did so, it would de facto be making the government debt of the crisis countries a common concern. In the event of a severe post-Grexit crisis, the disciplinary effect on governments and investors would be absent, since it would be painfully obvious that the euro zone countries would never again make a decision of this kind, i.e. de facto expulsion from monetary union. … but Grexit impact not insurmountable Markets would react negatively in the first place; yield spreads could rise substantially. In our view, though, the more likely outcome is that after a period of inevitable turbulence the markets would soon settle down again. Private investors have after all already scaled down their Greek commitments. And if Greece left Emu, bank customers in other crisis countries would be unlikely to start a run on their own banks and withdraw their deposits, since they would know that Greece was an exceptional case. They also know that the ECB’s OMT bond purchases and the finance ministers’ ESM bailout fund constitutes a safety net.
