A deal between Greece and its creditors might not happen. Several factors are in flux; Greek and northern European interests are not aligned; and personal animosities are in play. For Greece, an exit from the euro would not be easy, but if the alternative is endless austerity without debt forgiveness, its government may conclude that leaving the eurozone is the better choice.
Germany, for its part, would prefer to avoid a Greek exit – a position that Greek Finance Minister Yanis Varoufakis seems to have been banking on. But the German public largely wants to punish Greece, and German Chancellor Angela Merkel does not want to set a precedent for recurring bailouts of the European Union’s weaker members.
Failure to reach an agreement would be painful for Greece, which would face chaotic economic conditions. But an exit from the euro would also provide its government with new options – most notably, the ability devalue its currency to make its exports more competitive. For the rest of Europe, however, the risk is mostly on the downside, because beyond the obvious losses that would be incurred if Greece does not pay its debt to European governments and international institutions, there is the wider worry that the crisis could reverberate through the continent’s real economy.
There are three important risk channels through which Greece’s troubles could hit the European economy. The first is by destabilizing its financial institutions. The second is by disrupting the other EU member states in situations similar to Greece’s. And the third is by bringing about unexpected political outcomes. To be sure, each threat on its own seems containable. But to predict that they are likely to be contained is not the same as saying that they will surely be contained. And the combination of the three makes the impact on Europe of a Greek default and exit more unpredictable.
That is presumably why the markets are nervous. European long-term lenders were already reportedly pulling back following the announcement of a Greek referendum on the euro, with only the most reliable borrowers able to obtain serious shorter-term financing. If firms find they lack funding for planned projects, this could affect the real economy quickly, setting back the weak economic recovery further.
It is important to recall that the 2008 financial crisis started in the United States, prosaically enough, with the bursting of a housing bubble. The losses in the mortgage market were real, but modest and containable. On their own, they should not have driven the US into recession, much less the rest of the developed world.
The real trouble came when those losses hit the American financial system. At first, many authorities and observers thought that the crisis – beginning with the collapse of the US investment bank Lehman Brothers – could be contained. But the country’s financial institutions and the interconnections among them turned out not to be resilient enough to absorb the shock, and the resulting seizure devastated the real economy.
Optimists will point out that the European institutions most exposed to the turmoil in Greece have had years to prepare themselves. And, indeed, a significant share of Greece’s government debt has migrated from banks to robust public institutions like the European Central Bank and the International Monetary Fund. In that sense, those public institutions have already largely bailed out the private institutions.
But the risks have not been eliminated. The margin for error for the major banks and other financial institutions is narrow. Because they are still not strongly capitalized, modest losses from direct defaults and indirect losses from companies with business in Greece can threaten bank equity, causing bankers to cut back on lending. A few miscalculations in a major institution could have substantial repercussions. Making matters worse, central bankers have only a limited capacity to buoy the economy, as interest rates are still near zero.
The second channel through which risk and loss can spread from Greece is other heavily indebted countries, like Spain and Italy. So far, the financial markets have not panicked over the ability of these countries to repay their bonds. But a shift in the political situation – especially in Spain, where the left-wing Podemos party is doing well in the polls – could change that in an instant.
Finally, a Greek default and exit from the eurozone could unleash unpredictable political forces with a knock-on effect on the European economy. After all, it was the first wave of austerity in Greece that led to the election of Syriza, a left-wing party that few had expected would ever govern.
Further hardship and economic turmoil could produce governments even further out on the political spectrum (the neo-fascist Golden Dawn party is another beneficiary of Greece’s economic troubles) or generate considerable instability, with governments becoming unable to provide basic security, let alone encourage an economic recovery. Add to that Greek Prime Minister Alexis Tsipras’s overtures to Russian President Vladimir Putin, which may have been a veiled threat to the rest of Europe, and it is hard to know what might happen next. What is obvious, however, is that the downside risks for Europe are serious.
The good news is that Greece has yet officially to default or leave the eurozone. There is still time for one side or the other to concede or for the various parties to find a face-saving compromise. Indeed, that is what the IMF now seems to be seeking, judging by its recently issued report on Greece, which calls for better debt management in Greece and a debt restructuring.
Many in Greece desperately want to retain the euro. As for the rest of Europe, its decision-makers may not want to risk finding out whether the repercussions of a Greek exit really can be contained.
Mark Roe is a professor at Harvard Law School. He is the author of studies of the impact of politics on corporate organization and corporate governance in the United States and around the world.