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Greece’s Future After Grexit: Another Argentina? Or Mimicking the UK?

Euroskeptics have long provided a positive story of Greece after euro exit. Is it for real?

Credit: Steve Jurvetson - www.flickr.com

Takeaways


  • Could Greece face the same fate as Venezuela or Argentina – an ever-accelerating inflationary spiral into instability?
  • Are Euroskeptics deluded in their optimism over Greece after euro exit?
  • Greece is far away from the flexibility necessary to enjoy the full benefits of a weaker currency.
  • Who will be the real losers in case of Grexit? Greece’s poor and middle classes.
  • Devaluing Greece’s new currency will have a devastating effect on Greece's poor and middle class.

Once the immediate shock of Grexit is digested and the financial system restored, Greece will be faced with the challenge of rebuilding trust in its economy and financial system.

Depending on the choices made, Greece could hypothetically rebound like the UK did after it left the EU’s Exchange Rate Mechanism (ERM) in 1992, and grow like any low-income EU country thereafter.

But Greece could also sink in an ever-accelerating inflationary spiral – as happened in Venezuela or Argentina – losing population and political stability along the way.

It is too early to tell which scenario would play out, but there is a much bigger risk of an Argentina-type result, as opposed to a benign situation of tough reforms to restore credibility.

UK scenario: Government restores market access, enjoys competitiveness boost

Euroskeptics have long provided a positive story of Greece after euro exit. In their view, a devalued currency – many forecast an initial drop by at least 50% – and much reduced public and private sector debt after a general default would put Greece in a good starting position for a dynamic recovery.

An independent central bank would quickly restore credibility, if it avoided the risk of an ever-continuing inflationary spiral. Good macro and fiscal policies would, over time, restore market access for funding and attract international investment.

Tourism: Tourism in particular might benefit from increased cost competitiveness vis-à-vis Eurozone rivals, such as Spain or Italy. The sector could attract strong inward investment from foreigners and Greeks returning capital from abroad.

Manufacturing: Greece might attract the manufacturing bases of foreign companies, if it managed to stay in the EU. As imports become much more expensive, they might soon be substituted with domestically produced alternatives, broadening the manufacturing base and boosting employment.

Interest savings to fuel productivity: As Greece could save the 4% of GDP it is currently spending on interest on its public debt, it could redirect the money into public investment and education, building the foundations for stronger productivity growth.

Inflation: In the first years, high legacy unemployment and thus spare capacity would prevent inflation and, thus, a fast erosion of the newly competitive position.

Structural funds: The sharp drop in measured wealth would qualify the country for more EU structural funds. However, there are major differences between the UK in 1992 and Greece in 2015.

The UK was at the peak of macroeconomic flexibility after years of Thatcher reforms and its ERM exit came before the reform reversals started. Greece, by contrast, has adopted some reforms but remains far away from the kind of flexibility necessary to enjoy the full benefits of a weaker currency.

For instance, inflation is likely to kick in with much higher unemployment rates, in particular if Syriza strengthens Greece’s orthodox labor unions in collective bargaining and if it raises minimum wages.

In addition to Syriza making the Greek economy less flexible, being excluded from financial markets would mean years of austerity as Greece could not borrow. That would lead to a different, far less benign scenario. 


Argentina scenario: Populism continuously erodes economic foundations

The devaluation of Greece’s new currency, for all its potential positive impacts on cost competitiveness, would have a devastating effect on the living standards of Greece’s poor and middle classes, who would be faced with massive inflation.

Wealthier households have probably already parked and protected their money abroad and could benefit from the devaluation by repatriating part of their funds to buy up assets on the cheap.

However, the less well-off have little to park and repatriate. Instead, their drachma incomes would be insufficient to pay for imported food and energy.

For example, Greek food imports account for 12% of total imports, compared to only 7% in Germany. Much of that could probably be substituted with domestic produce, but that might not alleviate price pressures much as Greek farmers would prefer to sell their produce abroad at higher prices, too.

To alleviate the pain, the government might be tempted to try to restore political capital by using its newfound monetary independence to print the money it needs for a lavish social assistance program and public sector job creation. The central bank would lend directly to the government, thus creating permanent inflation.

Price controls for food and other goods may artificially contain official inflation rates, but may outsource the problem to the black market. Greece’s inflation would likely remain in double-digit territory, while the government would try to ensure its survival by blaming the rich for the failures and for keeping their money abroad.

Many in Syriza have such leanings, not least the party’s chief economist, John Milios, who advocates the monetization of government debt in the Eurozone as a whole.

This is the Argentina or Venezuela scenario. However, those countries can rely on their natural resources to bring in hard currency.

No obvious solutions

Greece, in contrast, would have to rely on tourism, which requires political stability. Restoring market access with Syriza leadership and policies would be extremely difficult, but would provide another convenient scapegoat for a populist government in Athens: international investors who do not lend to the country.

The structural weaknesses of the Greek economy, especially the labor market and product market rigidities and the stranglehold of vested interests over policy making would not go away with the euro.

If nothing changes, Greece would very quickly become uncompetitive again and have to devalue once more.

Successive devaluations would reduce the incentive for foreign and domestic investors to invest. This would lead to chronic underinvestment in the economy, making it more difficult for Greece to close the income gap with its European neighbors. Whether tourism can thrive in an environment of widespread poverty for large parts of the population is another open question.

Staying in the EU, while it keeps open access to the biggest internal market in the world and secures transfer payments, could also prove a challenge. Greeks might vote with their feet.

If the future government failed to restore economic prosperity, the EU’s free movement of labor could swell the ranks of Greek émigrés, further undermining the long-term potential of the economy.

Political stability at risk

It is difficult to predict how Greek politics would evolve in the longer run after a Grexit. In Argentina, left wing populists managed to hold on to power despite nearly permanent economic crisis by doing enough to pacify unrest.

In Greece, the pro-European movement would likely be much stronger. It would probably soon win elections and improve policies. But it would still take years to get into a position of seeking re-admission to the Eurozone.

Read Part I: How Grexit Could Happen

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About Christian Schulz

Christian Schulz is currently Senior Economist at Berenberg Bank in London.

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