Why Exiting the Euro is a Bad Idea for Greece

A number of world leaders, including the UK PM, have made it clear that the forthcoming election in Greece on the 17th of June will decide whether the country stays in the Eurozone (EZ) or returns to the old national currency, the drachma. Some greek politicians, however, would have you believe that the country can disentangle itself from the terms of the bailout and remain in the EZ at the same time. They argue that the potential cost of a greek exit to the world's economy is so high that Greece's creditors (the IMF, EU and ECB) would be willing to do anything to avoid it.

This is a miscalculation. The markets have already discounted the greek departure to a certain extent. A return to the drachma is not as unthinkable as it was a year ago and it is naive to think that behind closed doors EZ policymakers have not devised damage limitation strategies. Given that a unilateral greek withdrawal from the terms of the bailout would eventually -and quite quickly- lead to a voluntary return to the drachma, it would be honest for the politicians that support such unilateral action to admit that what they, in effect, advocate is the abolition of the euro.

So what can we expect to happen if the electorate votes an anti-bailout government in? Here is a likely (but not the only) scenario for the short run:

• The newly elected government declares that it wishes to renegotiate the terms of the bailout 
• Greece's creditors either give little way or none at all
• The government pulls out of the bailout agreement, misses the next loan instalment and defaults in its debt repayments
• Greek banks find themselves unable to borrow from the ECB, which no longer accepts greek debt as collateral, and there is a bank run
• Restrictions are placed on deposit withdrawals 
• The government nationalises the banks and starts printing money to recapitalise them
• A new exchange rate is set for the EURDRS (euro-drachma)
• Imported goods become (much) more expensive and greek tradable products and services gain competitiveness
• The greek government places rationing on the purchase of petrol and medicines
• The primary budget deficit cannot be financed through borrowing so the government resorts to inflationary finance (money printing)
• High inflation erodes stable incomes of pensioners and employees 
• Greece's output collapses and unemployment increases further

In the longer term, it is likely that net exports will improve due to the more favourable exchange rate but the outlook for consumption and investment is more uncertain.

• High inflation and interest rates will not help
• Necessary supply-side reforms will not have taken place and this will further hinder investment
• Public spending will be limited by the inability of the government to access the debt markets

A return to the drachma will not destroy Greece. But it will make it poorer.