July 6, 2015, 4:18 PM ET

If Greece Goes, Political Contagion Is the Bigger Risk in Europe

By Greg Ip

Demonstrators hold a banner reading “Rome with Athens” during a rally for the Greek referendum in downtown Rome’s Piazza Farnese on July 3.

Whatever the odds of Greek exit from the euro were last week, they have topped 50% since Greeks voted “no” to their creditors’ demands in Sunday’s referendum.

The question then becomes, if Greece goes, how likely is it that larger, more consequential countries will follow? A sober appraisal must conclude that the odds of a wider contagion are uncomfortably high.

To be sure, this is not my base case. That said, like many, I for months thought Greece and its creditors would strike a deal simply because their common interest in keeping Greece in the euro was so strong and the distance between seemed so small.

The more near-term risk of financial contagion from Greece still looks limited, as the restrained reaction of stock and bond markets today suggests. Yet the deeply divisive competing narratives that led up to Sunday’s resounding “no” suggest there’s a very real risk of political contagion to the rest of Europe over the next year or two.

Forecasting a series of interdependent events is more likely to be wrong than right, but with that caveat, here’s how a politically motivated contagion might play out about.

First, unless the negotiating positions of the Greek government or its creditors change materially in the next few days, Greece is headed for an unplanned and unwanted exit from the euro.

The longer Greek banks stay closed, the less likely they can reopen without a significant and costly recapitalization, and the deeper the damage to the Greek economy. Without more money from its creditors, the only way for the Greek government to reopen its banks and pay all its bills is by issuing a new currency. This may start out as a “parallel” currency, such as IOUs or scrip, and end up as a new drachma or some other euro substitute.

Second, with a new currency, Greece could experience a strong, short-term economic boom. To be sure, the first few months of transition could be painful and chaotic. But it has already endured most of the pain other countries go through during currency crises. Once the transition is complete, euro exit could produce a powerful monetary and fiscal boost.

In eight previous currency crises, Citigroup calculates the exchange rate fell by 40%. Some of the benefit will be eaten up by higher inflation, but even a 15% price spike would turn a 40% nominal drop into an inflation-adjusted devaluation of 30%.

As Daniel Gros has noted, the upside benefits of devaluation are limited by Greece’s stunted and uncompetitive export sector. But they’re not zero. A 30% cheaper Greece will siphon significant tourist traffic from other Mediterranean destinations.

In addition, once the Greek government can borrow in its own currency, it can swing from budget surpluses to deficits, providing an immediate fiscal boost.

As Joe Gagnon of the Peterson Institute for International Economics writes, “Few forces are more clearly demonstrated in economic history than the boost to spending and growth from a large and sustained real depreciation.”

Such a recovery will not prove Greece was right to spurn reforms or that Spain, Portugal and Italy have been wrong to swallow them. Without the structural reforms its creditors and prior governments had agreed to but failed to implement, Greece’s long-term potential growth rate may be negative, as the IMF’s recent analysis implies. But it can takes years for long-term reforms to bear fruit whereas the positive jolt from devaluation comes quickly.

Third, a strong Greek recovery would make the prospect of euro exit less terrifying elsewhere. Populist parties will be able to press their demands for less austerity and structural reform more effectively, perhaps enough to gain power.

At present, Portugal, Spain and Italy are all led by governments who have swallowed their structural reform medicine. All three are growing again, with Spain in particular on track for one of the region’s strongest growth rates this year.

But given how far their economies have sunk, this improvement looks awfully unimpressive to the average voter.  In Italy and Spain there was widespread sympathy for the “no” side in Greece’s referendum. If Greece prospers upon leaving the euro, these parties’ messages will resonate.

Fourth, if investors believe the odds have risen that another country will follow Greece out of the euro, they will start to pull back from their bond markets and banks.

Moderately higher interest rates would not be fatal. But the recovery in the periphery remains fragile and dependent on super-easy financial conditions. Higher rates bring the threat of a damaging spiral of weaker growth, a rising debt to GDP ratio, and yet higher interest rates.

No country need be forced out of the euro for an inability to borrow, thanks to the existence of the European Stability Mechanism and European Central Bank president Mario Draghi‘s vow to do “whatever it takes” to save the euro.

But to receive funding from the ESM or the ECB’s targeted bond-buying program, a country must agree to a bailout, and given how politically dangerous that is, governments may resist such a step until they have no other choice.

Fifth, the ECB’s “whatever it takes” pledge to protect the euro zone is only as effective as investors believe it to be, and this in turn depends not just on debtor countries’ willingness to abide by conditions of their loans, but on creditor countries’ willingness to extend them. Here’s a cautionary note from analysts at Barclays:
A Greek exit could introduce for the first time true losses to euro area governments (ie, tax payers) and to the eurosystem as a result of the various bailout mechanisms introduced since 2012…Could this trigger a backlash against ECB policies and potentially tie Draghi’s hands in doing “whatever it takes”?
Moreover, Barclays continues, the fallout from a Greece defaulting on its loans to the rest of Europe could generate a damaging political backlash:
Right-wing parties, such as AfD in Germany, Front National in France, Party of Freedom in the Netherlands, and True Finns in Finland, have repeatedly opposed bail-outs to periphery countries, especially to Greece. But even more moderate parties may question the bail-out mechanisms as the Greek default of 2012 was meant to be a one-off.
As I said, this is not my base case. The political appeal of the euro remains strong, and at this stage, other countries have far more to lose from leaving than does Greece. The current crisis in Greece is hardly the sort of thing any politician would want to emulate.

Moreover, the rest of the Europe still has the opportunity to learn. Countless mistakes got Europe to this place (starting, many would say,with the creation of the euro in the first place). One that stands out in particular was the failure to recognize that Greek debt was unpayable until 2012, by which point much of the damage had been done.

Even as late as last year, though, Greece’s creditors could have offered further debt writeoffs and relief from near-term austerity, at a time when Greece had a government more invested in carrying out the longer term reforms necessary for the country to grow.

If the rest of the periphery is to grow its way out of its debts, it needs monetary and fiscal breathing room so that structural reforms can take hold and bear fruit without alienating the population. The rest of Europe should ensure they get that breathing room, while it can still do some good.

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