What could be the consequences of Greece leaving the Euro Zone?
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What could be the consequences of Greece leaving the Euro Zone?

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At the beginning of May, elections held in France, Greece, and Germany signaled a clear and resounding rejection to the current plan of austerity in the south of Europe and bailouts orchestrated by the north of Europe.  The bailout plan will not be supported in the northern countries without some semblance of austerity in the southern countries, and the southern countries most likely cannot survive in the Euro Zone without some form of monetary or fiscal support.  What could be the consequences of Greece leaving the Euro Zone?

  • In the short term, a Greek exit from the Euro Zone would most likely lead to increased economic turmoil in the country.  The new Greek currency could see an immediate devaluation of up to 60 percent.  At the same time local banks and depositors could see their accounts decrease by the same amount.  This could lead to a run of bank failures and collapse in business lending. 
  • By buying large amounts of government bonds in the secondary market – or by having the banks act as intermediaries through the LTRO – the ECB could push down the interest rate for the debt of the peripheral governments.  Although this wouldn’t change the structural problems of those economies, this strategy could buy those countries time.  Since austerity measures force economic growth lower in the short term, time is exactly what these countries need.
  • The fear is that if Greece defaulted and caused investors to take losses on those holdings, then investors would probably pull their money out of Spanish and Italian government bonds.  Since the fixed conversion rate at which the Drachma joined the euro in 2001 would be retracted, there would be nothing keeping the other countries from doing the exact same thing.  Similar to the situation in the early 1990s when currency traders forced several countries, including Britain and Sweden, to withdraw from the currency bands forced by the European Monetary Union, traders would set their eyes on the bonds of the other peripheral countries. 

 

 

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