Default will be disastrous for Greece and the resulting contagion would be damaging for Europe. So goes the conventional wisdom. The only debate relates to the strength of contagion and the appropriate response of the vulnerable countries and of the cheque-writing country. Might the debate be misguided — because the basic premise is flawed?
There is one, overlooked, scenario in which default is not a disaster for Greece. If this is the case, the real, more existential, threat to the euro zone might be very different, in which, yes, the Greeks have the last laugh. Consider that scenario.
The immediate consequences of Greece leaving or being forced out of the euro zone would certainly be devastating. Capital flight would intensify, fuelling depreciation and inflation. All existing contracts would need to be re-denominated and re-negotiated, creating financial chaos. Perhaps most politically devastating, fiscal austerity might actually need to intensify, since Greece still runs a primary deficit, which would need to be corrected if European Union and International Monetary Fund financing vanished.
But this process would also produce a substantially depreciated exchange rate (50 drachmas to the euro, anyone?) And that will set in motion an adjustment process that in short order would reorient the economy and put it on a path of sustainable growth. In fact, Greek growth would probably surge, possibly for a prolonged period, if policy is sensible in quickly restoring and sustaining macroeconomic stability.
What is the evidence? Just look at what happened to the countries that defaulted and devalued during the financial crises of the 1990s. They all initially suffered severe contractions. But the recessions lasted for only one or two years. Then came the rebound. Korea posted nine years of growth averaging nearly six per cent; Indonesia, which experienced a wave of defaults that toppled nearly every bank in its system, registered growth above five per cent for the same duration; Argentina close to eight per cent; and Russia above seven per cent. The historical record shows clearly that there is life after financial crises.
This will also be true in Greece, even allowing for the particularities of its situation. Greece’s low export-to-GDP ratio is often invoked as precluding the possibility of high export-led growth. But that argument is far from iron-clad, because crises can lead to dramatic re-orientations of the economy. India, for example, managed to double its Greek-like export-to-GDP ratio within a decade after its crisis in 1991, and then doubled it again in the following decade even without a major depreciation of the currency. And Greece will experience a mega-depreciation, like the countries mentioned above, not a modest one. Such a change will necessarily create new opportunities for exports and convert many marginally non-tradable activities into tradable ones. These exports will, naturally, be unpredictable in advance. But the strong incentives that will be created for such activities by a super-competitive exchange rate are undeniable.
Suppose, then, that by mid-2013, Greece’s economy is recovering, while the rest of the euro zone remains in recession. The impact on austerity-addled and hope-deprived Spain, Portugal and even Italy would be powerful. Voters in these countries would not fail to notice developments in the hitherto scorned Greek neighbour. They will start to ask why their own governments should not follow the Greek path and voice their preference for exiting the euro zone. In other words, the Greek experience could fundamentally alter the incentives for these countries to remain in the euro zone, especially if economic conditions remained grim.
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At this stage, politics in Germany would also be affected. Today, Germany grudgingly does the minimum needed to keep the euro zone intact. But if exit to emulate Greece becomes an attractive proposition, the country will be put on the spot — and the magnanimity-to-replace-miserliness it shows will be the ultimate test of how much Germany values the euro zone. The answer might prove surprising. The German public might suddenly realise that the euro zone confers on Germany not one but two “exorbitant privileges”: low interest rates as the safe haven for European capital and a competitive exchange rate by being hitched to weaker partners. In that case, Germany would have to offer its partners a much more attractive deal to keep them in the euro zone.
Such a scenario would be rich in irony. Once Greece – the polluting pariah – is expelled from the euro zone, it might prove to be a much more dangerous threat than it ever was when it was inside the system. This is because from the outside, it may prove a contagiously infectious model to the countries remaining inside. This ongoing Greek tragedy could yet turn out not too badly for the Greeks. But tragedy it might well be for the euro zone and perhaps for le projêt europèen.
The writer is a senior fellow at the Peterson Institute for International Economics, Washington. This column previously appeared in the Financial Times