Greek Elections and the Eurozone’s Future

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Introduction

Greek parliamentary elections on June 17 (Reuters) will likely determine whether Greece stays in the eurozone. The outcome may also foretell whether the eurozone’s two-year-old sovereign debt crisis will plunge the single-currency union--and perhaps the global economy--back into a full recession. Contagion in the euro periphery has already been spreading. Spain was forced to request an EU bailout on June 9 (Telegraph) for its beleaguered banking sector, amid mounting fears over rising government bond yields (WSJ) in that country and in neighboring Italy.

What is at stake in the June 17 Greek parliamentary elections?

Greek parliamentary elections on May 6 yielded significant gains for the country’s fringe anti-austerity parties (WSJ), with the radical leftist Syriza party coming in second place. Greece’s main political parties--the conservative New Democracy party and the Socialist Pasok party--failed to form a coalition government with Syriza, which has vowed to overturn EU-mandated austerity measures.

The June 17 vote is expected to determine whether Greece will continue to abide by the terms of two EU-IMF bailout packages--both requiring strict budget-cutting measures--and consequently continue to receive financing from its international creditors. A victory for Syriza would likely mean the unraveling of Greece’s bailout agreements with the EU and the IMF, paving the way for a disorderly Greek default. Such a scenario would undoubtedly mean more losses for Greece’s private and official creditors and also potentially signal a Greek exit from the euro, with significant knock-on effects for the European financial sector, other eurozone sovereigns, and the larger world economy.

How has EU-mandated austerity fueled Greek political unrest?

The overextended Greek economy--which maintains a debt-to-GDP ratio of over 160 percent--was the first to fall prey to the eurozone sovereign debt crisis. In May 2010 the Greek government had to request a $163 billion financial bailout package from the EU and the International Monetary Fund as the country’s debt burden became unsustainable and a default seemed imminent.

But even with that loan--coupled with spending cuts and tax hikes--Greece was unable to put its financial house in order and avoid defaulting on its debt obligations. The EU and the IMF agreed in October 2011 to provide Greece with a second bailout package worth $178 billion. That deal included an approximately $130 billion debt write-down with private creditors. In exchange for the deal--finalized in March 2012--Greece was forced to implement a new wave of budget-cutting measures, which put more Greeks out of work and plunged the economy further into recession.

The worsening economic outlook and continued belt-tightening for most Greeks has fueled anti-eurozone--particularly anti-German--sentiment, prompting a rejection of Greece’s mainstream political parties in last month’s elections. In the weeks leading up to this weekend’s vote, eurozone stability--particularly in Spain--has in part been held hostage to Greece’s uncertain political situation.

What happens to Greece if it exits the eurozone?

If Greece abandons the euro, the newly adopted drachma could lose half or more of its value relative to the euro, while driving up inflation, according to the Foundation for Economic and Industrial Research. "The prices of imported goods would skyrocket, putting them out of reach for many," explains the Associated Press.

Still, after the initial storm, a Greek exit would strengthen Greece’s export market and make its economy more competitive, Costas Lapavitsas, a professor at University of London, contends in the Financial Times. "Restoring competitiveness would also boost employment, after the initial shock. Above all, exit would allow the lifting of austerity, giving Greece the breathing space it needs to restructure its economy," he argues.

What are the implications of a Greek exit for Europe?

Such an unprecedented development would potentially unravel the whole currency bloc. An exit would force losses on Greece’s official creditors--including the European Central Bank, eurozone governments, and the International Monetary Fund--and financial institutions throughout Europe that hold Greek debt.

Private holders of Greek debt arguably have the least to lose, since they already took a significant hit during Greece’s orderly restructuring earlier this year, argues CFR’s Sebastian Mallaby. While banks and other private holders of Greek debt would still incur losses, other avenues of contagion to the eurozone’s financial sector are more consequential. One avenue would be through Greek companies that have borrowed through non-Greek lenders; the other is psychological. "You might start to see a bank run developing across peripheral Europe," Mallaby explains.

In the event of a Greek exit, "large-scale ECB intervention would be necessary to stabilize the system, along with intervention from Germany, the European Stability Mechanism, its predecessor the European Financial Stability Facility, and the IMF, potentially costing hundreds of billions of euros," Coutts investment strategist Georgio Tsapouris told Reuters.

Still, the London School of Economics’ Iain Begg says the EU has "steadily been building up its firewall against contagion spreading from Greece to other sovereigns, and the betting is increasingly that the storm could be weathered."

What are the implications of a Greek exit for the global economy?

The eurozone sovereign debt crisis is already undermining the global economic recovery; a Greek exit from the eurozone could drag the world economy back into recession.

Sluggish growth in the eurozone has contributed to reduced consumer demand in Europe, hurting global export markets. This is particularly so in East Asia, where many countries--including China--are experiencing an economic slowdown.

The eurozone crisis has put the United States at risk because Europe is the largest U.S. trading partner, and because U.S. financial institutions have close ties to those of Europe. A "disorderly Greek exit, or just unraveling of the commitment to the eurozone, would have serious repercussions in the U.S.," says Columbia University’s Richard H. Clarida. "The cost of the capital of the banks would go up, spreads would go up, and, as credit spreads rise, the assets on banks’ balance sheets would lose value," Clarida explains.

In May, the Organization for Economic Cooperation and Development cited the eurozone crisis as the "biggest downside risk facing the global outlook" (BBC), warning of potential "spillovers beyond the euro area, with serious consequences for the global economy."

What are some policy solutions for addressing the eurozone crisis?

Many economists and analysts have called for Germany, the eurozone’s de facto leader, to soften its rigid austerity approach to the sovereign debt crisis and back pro-growth policies to prevent Europe from sliding back into recession--an outcome that could ultimately increase the long-term debt burdens of peripheral euro states. Policy proposals include spurring greater European fiscal and political integration (Economist), notably through a banking union, and mutualizing debt through so-called euro bonds.

Others have called for the European Central Bank to play a greater role (WSJ) in alleviating the crisis. Channels through which the ECB could do this include extending its Long-term Refinancing Operations--which provided European banks three-year loans at near-zero interest rates--and restarting its purchases of government bonds in Italy and Spain in the secondary markets. At the same time, there are calls to allow the EU’s new rescue fund, the European Stability Mechanism, to buy up government bonds on both the primary and secondary markets.