Greece and the Threat to the Euro

I read time and again, for instance here, that Greece’s debt crisis “threatens the euro”. Indeed, there are lots of right-minded people around Europe who worry deeply about this threat and have determined that a Greek default has to be avoided to save the euro. I’m having trouble, however, figuring out what that this is supposed to mean.

There seem to be different interpretations of what the “threat to the euro” is. The more dramatic interpretations invoke the idea of an existential threat. Others view it as involving reputational harm. I’ll take each of these ideas in turn.

The Existential Threat

Some people apparently think that a Greek fiscal default will, inexorably, lead to Greece leaving the euro. I don’t see why this is the case.

One narrow interpretation of this idea was provided on Morning Ireland today by Daniel Gros. He noted that if Greek government bonds could not be use in ECB repo operations than this would shut Greek banks out from part of the operation of the Eurosystem. But this is indeed a very partial shut out from the EMU, since the euro would still be legal tender in Greece and, indeed, there is no legal reason why Greek banks have to use Greek government bonds as their principal collateral for ECB operations.

Some people think that Greece’s problems stem from a recession due to an over-valued exchange rate and that the Greek government may decide to leave the euro to devalue their currency and thus promote growth. This is one potential interpretation of the “threat to the euro”. However, as best we can tell (insert mandatory caveat about Greek economic statistics) Greece’s recession has been milder than the rest of Euro zone’s. According to the Autumn 2009 release of the excellent Statistical Annex to European Economy, Greek GDP is estimated to have declined 1.1 percent in 2009 compared with 4 percent for the Eurozone as a whole.

Even if an over-valued exchange rate – rather than fiscal mis-management – was Greece’s key problem, it is incredibly unlikely that alleviating this particular problem via exiting the euro would offset the other problems that this would impose such as the return of exchange rate premia on sovereign debt and the host of legal and contractual problems associated with re-introducing a new currency. Nor, as best as I can tell, has anyone explained why the Greek government would choose the moment of a technical default on its debt (failing to roll over its debt as the EU cavalry chooses not to arrive) as the moment to induce further mayhem by leaving the euro.

I suspect some people have in mind that a Greek default would lead somehow to them being expelled from the Eurozone, perhaps because they have brought shame upon the noble euro project. However, this idea of expulsion – lurking in the background of the Gros\Mayer EMF proposal – is not in any way realistic. A recent ECB legal working paper states that “a Member State’s expulsion from the EU or EMU would be legally next to impossible.”

It’s also worth remembering that EMU survived for a number of years without Greece (and for longer without Slovenia et al) and that it would carry on even in the unlikely scenario of Greece leaving.

A final possibility is that, out of disgust at sharing a currency union with defaulting nations such as Greece, core euro nations such as Germany decide to re-establish their own currency. I don’t know if anyone has ever suggested this as something that could happen but it doesn’t sound in any way plausible.

I conclude from all this that the existential threat is overstated.

The Reputational Threat

So the euro would carry on even if Greece defaulted. What’s the big issue then?

Well, it is possible that if Greece defaults, that bond markets will perhaps lose faith in Irish, Italian or Spanish sovereign bonds and there will be a wave of distruptive fiscal crises across Europe. The idea of a European backstop can prevent such an outcome, though it does raise questions: Aren’t Spain and Italy too big to save from default? Doesn’t the existence of the implicit European safety net make it harder politically, rather than easier, for governments to impose the necessary fiscal adjustments?

These are valid points for discussion but they don’t have anything, per se, to do with the euro. They would apply just as validly if the UK was on the verge of fiscal crisis, even though they are not in the euro.

The issue for the euro appears to be that it would “damage the image” of the euro. You might read this kind of thing a lot but it’s worth keeping in mind that about 90 percent of what’s written in newspaper articles about currency movements is complete claptrap – today’s award for currency claptrap goes to this Irish Times article for its mentioning of the “psychological key level of $1.35”!

In practice, the vast majority of demand for euros will be unchanged by a Greek default. It is possible that such a default would reduce global portfolio demand for euros to be used to purchase various types of financial assets because of a perceived increase in risk. And it is possible that this could, at least temporarily, reduce the value of the euro.

But who says this is a bad thing? The Eurozone economy is still in pretty bad shape and could well use the boost to net exports that is coming from the current round of currency depreciation.

The bottom line here is that despite the widespread agreement of the great and the good that Greece’s problems are “a threat to the euro” and so it must be rescued to save the currency, it just ain’t necessarily so. There may be good arguments for bailing out Greece, but the threat to the euro is not one of them.

21 thoughts on “Greece and the Threat to the Euro”

  1. There were defaults of individual states within the USA in the 19th century and this did not lead to the break-up of the dollar zone.

    On the other hand, playing devil’s advocate, one could argue à la Eichengreen (in a piece linked to often on this blog) that exiting the euro is de facto impossible since it would bring about a financial collapse — sovereign default plus banking collapse. If this is accepted, then would the cost-benefit calculus of staying in the eurozone change once such a financial crisis had already occurred? (I should add that perhaps this calculus might be more likely to take place in Spain, say, or Ireland, than in Greece — in which case to make the argument fly you might want to argue that contagion would be a risk.)

  2. Bags I drag the (as usual excellent) thread off topic . I gotta disagree with Karl on one issue “psychological key level of $1.35”!”
    Theres a good deal of evidence, some of it from my own fair hands, that (for whatever reason) markets do behave differently around 0 and 5 ending points. As so often with moderately efficient markets, these then disappear when identified as traders act on same. See references below
    A mor epertinent issue is raised by Karl in the bottom : we export (as per the CSO 2008 data) 86b , of which 37 was to “other eu” which we can read as mainly within the Eurozone. Commentary in the msm on the benefits of a “strong” or “weak” (versus whom?) currency rarely note the divergent effects

    Dorfleitner, G., Klein, C.
    Psychological barriers in European stock markets: Where are they?
    (2009) Global Finance Journal, 19 (3), pp. 268-285

    Aggarwal, R., Lucey, B.M.
    Psychological barriers in gold prices?
    (2007) Review of Financial Economics, 16 (2), pp. 217-230

    Mitchell, J., Izan, H.Y.
    Clustering and psychological barriers in exchange rates
    (2006) Journal of International Financial Markets, Institutions and Money, 16 (4), pp. 318-344

    Doucouliagos, H.
    Number preference in Australian stocks
    (2004) Applied Financial Economics, 14 (1), pp. 43-54

    Mitchell, J.
    Clustering and psychological barriers: The importance of numbers
    (2001) Journal of Futures Markets, 21 (5), pp. 395-428. Cited 14 times.

    Cyree, K.B., Domian, D.L., Louton, D.A., Yobaccio, E.J.
    Evidence of psychological barriers in the conditional moments of major world stock indices
    (1999) Review of Financial Economics, 8 (1), pp. 73-91

    De Ceuster, M.J.K., Dhaene, G., Schatteman, T.
    On the hypothesis of psychological barriers in stock markets and Benford’s Law
    (1998) Journal of Empirical Finance, 5 (3), pp. 263-279.

  3. Even if Greek sovereign debt was no longer acceptable, it could be rolled into Asset Backed Securities and over-collateralised to reach an acceptable rating… it would mean a lower return/higher cost, but it could be done. No?

    It would probably be a boost for exporters, but what of imports? In particular, oil and gas?

  4. The Euro (and the EMU) was always as much a political as an economic project – if not more. Within the confines of the G&SP it was assumed that fiscal harmonisation – and, perhaps, a measure of economic policy harmonisation – would evolve. The values and disciplines of the core would radiate outwards. All this, with increased co-ordination in policing, criminal justice, security, immigration policy and defence, would advance political integration. There was no expectation, or fall-back position in the event, that the PIIGS would lie, cheat, lose the run of themselves or all three.

    An appeal to EU solidarity is unlikely to rally the masses in Germany or France to the cause of a Greek bail-out; political intregration has always been pursued surreptitiously; and now is not the time to raise that flag.

    So, perhaps, we should not be surprised that all sorts of non-reasons are being trotted out.

  5. the anti dollar has a chance of being a reserve currency, but not with the the threat of greek default, hence they have opted for IMF style management but with EMU backing. I actually see german influence as being a key risk in the future more than that of european wide currency collapse, perhaps germany at last will be ze king of europe without firing a single shot.

  6. @Karl Whelan

    Maintaining the ‘solidarity bond’, which is largely psychological, is a prerequisite to any future fiscal/monetary or institutional reform – break this psychological ‘bond’ and the possibility of cross-EZ cooperation on such major reforms, which is extremely difficult as the Greek saga shows, drifts towards zero – which presents a much, much, much bigger problem than sorting out Greece, or Spain, or Portugal, or Italy. Or sorting out German imbalances from an internal EZ perspective.

  7. @Karl Whelan

    & take a scan at this graphic – posted a while back …… not only Greeks!
    From Bloomberg:
    Feb 28, 2010

    “German and French banks’ “enormous” exposure to Portugal, Ireland, Greece and Spain explains why Europe’s biggest economies are moving to rescue their southern neighbors, Societe General SA said today in a report titled “Shotgun Greek Wedding.” The CHART OF THE DAY shows how much money German, French, Swiss and U.K. banks have at stake in the so-called PIGS countries. Banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the so-called PIGS.”

    Lots of Green in there – Yes, we too are EUROPEAN …. an punching above our weight !!! I support Solidarity Bond – in the national interests! Post German election in May – expect further moves ……….

  8. @ David O’Donnell

    A lot of the green relates to the IFSC – – German banks lending to themselves!

    Greece only defaulted five times since its independence in 1829 according to the Reinhart/Rogoff study This Time Is Different. This compares to eight times for Germany and France and 13 times for Spain since these countries gained independence (I’m not sure who G/F and S gained independence from!).

    Some more data here:

  9. The key risk to the Euro project if Greece were to exit is political.

    The Euro is a monetary subset of the greater European project. For some this project has elements of a pseudo-religion. It is supposed to move steadily and inexorably towards a sort of heaven on earth: a fully-integrated European federal state.

    The fact that economic considerations (of an optimal currency area character) were wholly subordinated to political considerations (wanting to be fully paid up members of the European club) in establishing EMU is symptomatic of the messianic-lite nature of the project.

    What started out as an economically sensible (and economically flexible) free-trade zone (EEC) has been transmogrified into a nascent superstate (EU) which promotes boom and bust through its economically inappropriate monetary union.

    Any failure to keep Greece within the monetary subproject would call into question the full viability of the wider project and could cause a crisis of faith among devout Eurocrats.

  10. @Karl – I agree with your analysis. The key issues are possible contagion, reputation (more political than economic reputation) and the potential loss to banks in Germany and France. As you say, what’s wrong with a weaker Euro?

    Nobody commented on the heavy involvement of Barroso – he is Portugese and perhaps more than Spain and Ireland, Portugal is next on the hitlist of speculators.

    Many in Germany would love Greece to pull out of the Euro – they made a mistake letting them in but that’s spilled milk now.

    @David O’Donnell – I am no longer convinced that there will be a significant change in the German approach to the problem after the NorthRhine-Westfalia election. Merkel has backed herself into a position she can’t change from without huge political damage in Germany.

  11. Greece in relation to the EU as a whole is but a pimple on an elephants derriere. We all know what that makes Ireland. As Frau Merkel played the cold, lukewarm, warm game with Greece she accomplished two things. The first and most important was to create uncertainty in currency markets and the second was to mollify the electorate. She was very successful in that the EU declined 8% against the US$ and the waters are sufficiently muddied by bringing in the IMF that she is off the hook with respect to having the hard working and honest volk saddled with the bailout of profligate or worse Greeks. Overshadowing the whole shebang is as Karl pointed out Portugal, Spain, Italy, I would add France and Belgium to that list. You can rest assured that the German, French, UK, Austrian and Swiss banking fraternities are lobbying their respective governments in a frantic attempt to save themselves from the risk posed by their sovereign debt exposure. Self interest makes strange bedfellows and if Ireland was standing alone in its present predicament we would be bailed out in a flash. As Sarah O’Connor stated, there is no mystery as to why the Irish gov’t embarked on its austerity program with alacrity. The need to roll over short term low cost debt ranks right up there with NAMA on our list of risks. The unanswered question is, did we impress Gross of Pimco enough to ensure he will take a tranche of our future debt offerings.

  12. @KW and KO’R

    I have always interpretted the much quoted Eichengreen paper to show that it is practically impossible for a weak economy to leave the Euro.

    But he does show that it would be quite practical for one or more strong economies to leave and found their own new currency(ies). So in the event that the entire Euro project descended into farce with 1923 looming, Germany, Austria, Luxembourg and the Netherlands could set up the Euro Mark II, to commony known as the Mark.

  13. @Michael Hennigan

    Thanks Michael – the IFSC both clarifes (as too much Green) and further complexifies my amateur sleuth attempts to map and understand ‘financialization’ (-;

    “We hope that it will reassure all the holders of Greek bonds that the Eurozone will never let Greece fail,” said Herman Van Rompuy, president of the European Council, at a press conference. “If there were any danger, the other members of the Eurozone would intervene.”


    we await election results … but a push on in internal EZ institutional reform? & on Derivatives/CDSs etc This story is far from over …

  14. Fiat currencies can work but to date, all have failed. (Discuss!)

    The current crop are devaluing as fast as possible and the best way to do that is to sell it down, while talking it down. See! It works! The reserve currency, freed for the moment from sell offs as countries start to wake up, is commodities. As a result commodity rich countries are not devaluing their fiat crap. The US$ and the Euro are both dropping. So is the GBP. Put into punts, what is the current exchange rate betwixt Ire and Eng? (Or “that is what you get for buying in GB”!)

    Fiat currencies inspire dishonesty in states, Discuss! Greece does not matter hence it is the ideal way to slowly devalue the Euro. When they get to talk like this about Italy, look out belooooooow!!!!! Remember, people, the MSM are for hire. PR.

    Spain got its independence from the Moor! (The end of the first Islamic invasion…..!)

  15. The threat to the euro is very simple, it is the political consequences of mass unemployment and continued downward cost / wage adjustment.

  16. The threat is the moral hazard. If Greece get a bailout on favourable terms, we’d be mad not simply to forget about fiscal austerity and let rip with the fiscal pumps.

    And that is where your game theory comes in handy. You really need to be the first to play this hand. Greece looks to be getting the first mover advantage.

  17. Greece and Spain won’t pay back. This was a calculated Risk, and a Lesson for the Banking System. The only thing Germans can do is:
    REPOSSESS 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
    U.S.A must REPOSSESS 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
    Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.
    Greece’s problem is too much debt. Greece has a budget deficit of 12.7% of GDP – meaning that the country is spending 12.7% more than the value of one year’s economic output.
    Greece is no different to a serial credit card borrower who can’t pay back his loans. But just like a serial credit card borrower, as long as Greece keeps relying on borrowed money to fund itself, the problem won’t go away. It will just get worse.
    Don’t worry; the ECB, the Fed or both will print the money.
    And all of us will share the pain, with our hard-earned money.
    Bad is never good until worse happens.

  18. Greece made its own bed. Despite the decry of outside banks, Greece spent way beyond its means and then recruited the help of the financial system to outright hide it’s debts from the very EU neighbors it was trying to con. For all the talk about investigating Goldman, the EU really needs to stand up for itself and investigate Greek figures, and wonder why it’s allies decided to lie about their finances.

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