Can Europe really withstand a Greek exit?

Throughout the European sovereign debt crisis, European policymakers have displayed a great capacity for self-delusion. Today would appear to be no exception. As the prospect of a Syriza victory in Greece’s Jan. 25 elections becomes all the more likely, European policymakers are making every effort to convince themselves that Europe is now in a very much better position to withstand a Greek exit from the euro than it was some three years ago. They do so in seeming disregard of the eurozone’s highly troublesome public debt situation, its susceptibility to contagion from a Greek financial market meltdown and its diminishing political ability to put its public finances back in order.

{mosads}A striking feature of the European economic periphery today is how very much higher its public debt to gross domestic product (GDP) ratio is than it was some three years ago. Leaving aside Greece, whose public debt to GDP ratio has reached a staggering 175 percent despite a major debt restructuring exercise, the corresponding ratios for Ireland, Italy and Portugal are now all above 125 percent. This is some 15 to 20 percentage points higher than it was some three years ago and more than double the Maastricht criteria of 60 percent. At the same time, while Italy’s budget is now in approximate balance, Ireland, Portugal and Spain are all running budget deficits in excess of 4 percent of GDP. These deficits keep adding to these countries’ public debt mountains.

A further notable feature of the European periphery is how weak its economic recovery has proved to be and how entrenched deflation seems to be becoming. Despite the fact that the overall European economy is yet to regain its pre-2008 peak, it now faces the very real risk of a triple-dip recession, with output growth being particularly weak in the periphery. This makes it all the more difficult for these countries to work down their debt to GDP ratios to more reasonable levels.

Worse yet, the overall European economy has now succumbed to outright price deflation, with deflation in the individual countries of the periphery now at anywhere between 0.5 percent and 2 percent. Such deflation only adds to the real burden of these countries’ debt levels. Sadly, there is every prospect that deflation will become even more severe in the period immediately ahead, since there is very little prospect that the large labor and output market gaps currently characterizing these economies will be closed anytime soon.

Simple analysis suggests that in today’s context of deflation, countries like Ireland, Italy and Portugal all need to attain and sustain primary budget surpluses of between 4 and 5 percentage points of GDP to restore public debt sustainability. Yet they need to do so at the very time that the political backlash against austerity in Europe has never been stronger. Throughout the European periphery, the political center seems to be crumbling while anti-European parties on both the extreme left and the extreme right of the political spectrum appear to be on the march. This has to raise serious questions about these countries’ political willingness to sustain a few more years of painful budget austerity.

The danger of a Greek exit is that it would almost certainly lead to a Greek economic and financial market meltdown as Greek depositors ran on their banks. It would also clearly signal to depositors in the rest of the eurozone periphery that euro membership was not irrevocable and that the European Central Bank (ECB) was not always there to act as a lender of last resort to their banks. This will all too likely fuel capital flight from these countries and cause markets to again focus on their precarious public finances.

The European optimists argue that should markets again focus on debt sustainability issues, Europe now has in place financial safety nets that it did not have before. These include the establishment of the European Stability Mechanism and the establishment of the ECB’s Outright Monetary Transaction program. However, what European optimists choose to ignore is that by their own rules, those safety mechanisms can only be activated for countries that are prepared to sign up to International Monetary Fund (IMF)-style budget adjustment programs.

In the context of rising populism at home, IMF-style austerity is the last thing for which countries like Italy or Spain would want to sign up. This consideration should make European policymakers less cavalier in their statements about a Greek exit not posing a real threat to the rest of the European periphery. Instead, what they might want to do is spend more time figuring out contingency plans for handling the likely fallout to the rest of the eurozone from the increasing likelihood of a Greek euro exit before the year is out.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.