The European flag flies in front of the Parthenon in Greece – but for how much longer? Photograph: Louisa Gouliamaki/AFP/Getty Images
Julia Kollewe, The Observer, 13/5/12
Two years ago, the prospect of a state falling out of the single currency area was unthinkable. But as the Greek electorate turns against austerity, it is becoming all too easy to picture how breakup might happen.
Mass unemployment in Greece, inflation at 50%, a devastating recession and Greeks heading for the borders – that's the apocalyptic scenario being painted by some economists in the increasingly likely event that Greece leaves the eurozone in coming months.
Greece is small in economic terms: it contributes only 2.2% of eurozone GDP. But withdrawal from the single currency would unleash chaos in the country, and have potentially severe knock-on effects on other euro nations.
US bank Citigroup now reckons there is a 75% chance that Greece will pull out of the single currency within the next 18 months. This would set a precedent, and the eurozone could quickly unravel if other vulnerable members like Spain and Italy were to follow suit.
The fallout from a Greek exit would quickly wipe 20% off Greece's GDP, send inflation soaring to 40%-50%, and see Greece's debt-to-GDP ratio soaring over 200%, say analysts at French bank BNP Paribas.
Such predictions are obviously estimates – the actual outcome would depend on how large a devaluation Greece would take if it reverted to the drachma. Dawn Holland at UK thinktank the National Institute of Economic and Social Research expects a 50% fall in the value of the currency. By comparison, the Argentinian peso lost 70% in value after the country's bankruptcy a decade ago.
The practicalities of unpicking the eurozone are mind-boggling. Philip Shaw, chief economist at Investec, says: "It was bad enough putting the euro together, but splitting it apart, or a little bit of it, would be more complex still. One issue would be what is denominated in euro and what in, say, drachma. Not easy."
But it may be that, however challenging, that scenario will have to be faced. The warning signs are already clear: it is not difficult to envisage a sequence of events over the coming months that would leave Greece no choice but to break away.
1. ELECTORAL PARALYSIS
Greece's election last week produced a messy result, with the two hitherto dominant mainstream parties suffering huge losses. Socialist leader Evangelos Venizelos, the former finance minister who negotiated Greece's second, €130bn bailout, tried to put together a government of national unity with his conservative counterpart, Antonis Samaras. However, the two parties jointly had 149 seats in parliament, two short of a majority, and could not have ruled alone.
The political deadlock has triggered repeated warnings from European leaders that Greece could be thrown out of the euro if it does not stick to the spending cuts and economic reforms stipulated for the bailout – the only thing that that keeps Athens from a messy bankruptcy, which would mean a halt to paying government workers and pensioners.
If Greece cannot form a government – and the majority of voters backed parties who are against abiding by the agreed bailout terms – political unrest will grow on the streets and its neighbours will get increasingly nervous. A second round of elections in mid-June could produce an even larger anti-austerity vote.
2. THE MONEY RUNS OUT
So what happens if Greece remains without a government? Belgium recently set a modern-day record when it remained without a government for 541 days. Or what if a government is formed that does not adhere to the strict bailout conditions?
The "troika" – the European Union, International Monetary Fund and European Central Bank – would probably turn off the taps and bailout money would stop flowing to the highly indebted country. At the same time, Greek banks would probably be cut off from the liquidity provided by the ECB.
According to Jens Nordvig, global head of currency strategy at Nomura, this would mean that the euros held by Greek banks would become separated from the euros in the rest of the eurozone and over time would turn into a separate currency.
He believes that there will be a "Grexit", as it has become called, and that it will come as a result of "a political accident".
Christian Schultz, senior economist at Berenberg Bank, says last week's €4.2bn payment could be the last injection of bailout money and a run on its banks would become likely.
"If Greece continues to redeem bonds, and pay interest, it could run out of cash by July," he says. "After that, the government would be unable to make full euro payments to pensioners and public employees. It may instead make these payments in promissory notes, which could form the nucleus of a new currency. Greece would face financial infarction: the country's banks would face a bank run."
The last time this happened – in Argentina in 2001 – some people started sleeping outside cash machines in Buenos Aires so that they could withdraw as much money as possible once the machines has been refilled.
The Argentinian government froze all accounts, banned individuals from taking out more than 250 pesos and halted withdrawals from dollar-based accounts. But the so-called corralito strategy didn't work. The courts supported tens of thousands of depositors and instructed the banks to repay them immediately in full. The government's policies sparked bloody protests that ended up toppling the government as Argentina plunged into a deep recession.
3. NEW CURRENCY, NEW BANKS
To counteract a run on its banks after a debt default, a new Greek government would have to freeze bank accounts and introduce capital controls to prevent the country's citizens from moving money abroad. But analysts at Fathom Consulting believe Greeks would be "likely to conclude that the space under their mattress would be safer than the vault of a Greek bank", making a series of bank runs a strong possibility.
The government would also have to pass a currency law and start up the banknote-printing machines. It is not inconceivable that Greece might already be quietly printing new money: when Slovakia broke away from Czechoslovakia in 1993, it emerged that it had started printing its own currency six months earlier. The money was stored in a warehouse in London and shipped to the newly created country once the breakup became official. To minimise the likely chaos that would ensue, the Greek government would probably choose to reintroduce the drachma over a weekend.
Because the Greek banks are entirely reliant on the ECB for liquidity, they would become insolvent as soon as the money stopped flowing. The Greek government would have no choice but to create new banks, with substantial government involvement. Iceland was forced to do this during the financial crisis: it created three new banks from the ruins of the old bankrupt lenders.
4. GREEKS HEAD FOR THE BORDERS
The Argentinian example shows that a Greek debt default and exit from the eurozone are likely to have dire economic and social consequences, at least in the short term. The country will become isolated. With lending drying up and accounts frozen, small businesses will go bust, exports plunge and the country will lurch deeper into recession. "Consumption could drop by 30%," says Nordvig. "There will be some pretty extreme effects."
In Argentina's case, the largest ever sovereign bankruptcy – defaulting on $93bn of foreign debt – triggered a 60% fall in domestic consumption as household savings were wiped out and inflation rose.
The depreciation of the new currency will make imported goods more expensive and drive up inflation. Mass unemployment is likely, as is an exodus of young skilled workers. If tens of thousands of Greeks headed to the borders, they might even be closed. Greek soldiers patrolling the roads and ports to keep their fellow citizens in? It is not impossible.
The examples of Iceland and Argentina, where recovery has been impressive, offer some hope, though - although Argentina's default took place at a time when the global economy was on the up.
5. THE SHOCKWAVE SPREADS
Holders of Greek government debt would undoubtedly suffer, as they risk having their assets redenominated into a rapidly falling new Greek currency – as would holders of Greek corporate debt. Returning to a Greek national currency would create all sorts of legal problems with business and government contracts. Greek companies forced still to make payments in euros will see costs and interest payments on euro loans double. Then, of course, there is the cost of bolstering the other vulnerable nations – such as Portugal and Spain – which the Institute of International Finance has recently estimated could run to €1 trillion. This burden would fall on the taxpayers of the remaining 16 eurozone states.
Once the precedent of a country leaving the eurozone is established, stability and confidence in the rest of the currency bloc would be shot to pieces and in all likelihood send it back into recession. "We have long held the view that, following the departure of just one member, a total breakup would be very much on the cards," says Fathom Consulting.
Richard Ward, chief executive of the Lloyd's of London insurance market, on Friday warned that a eurozone breakup could lead to a "potentially terrible recession for the globe".
And UBS says: "The costs of breakup go way beyond the economic. To quote Shakespeare, in the event of a fragmentation of the euro, economists will have little to do but 'cry havoc, and let slip the dogs of war.'"
