Can the Eurozone Withstand a Grexit?

A woman holds a placard reading 'No cuts' during a demonstration in support of Greece, in Madrid on July 5, 2015. Today, near
A woman holds a placard reading 'No cuts' during a demonstration in support of Greece, in Madrid on July 5, 2015. Today, nearly 10 million Greek voters take to the ballot booths to vote 'Yes' or 'No' in a referendum asking if they accept more austerity measures in return for bailout funds. The referendum on a deal with European governments, the European Union (EU) and International Monetary Fund (IMF), was called by Prime Minister Alexis Tsipras on the night of June 26-27. AFP PHOTO/ JAVIER SORIANO (Photo credit should read JAVIER SORIANO/AFP/Getty Images)

Is the eurozone sufficiently strong to deal with contagion if Greece leaves? It is precisely the uncertain answer to this question that explains a great deal of the game of chicken that Greece and the Europe have been playing.

On the one hand, the Greek government has been betting that fear of contagion (and some other deeper political factors) will make the European leaders capitulate. On the other hand, many European leaders are convinced that the costs of keeping Greece in will be actually larger than the costs of letting it go. So they have been playing tougher than many of us expected.

But who is right? The eurozone is now, indeed, better equipped to navigate difficult waters than it was in 2012. Vulnerable countries, such Spain or Portugal, are growing stronger, their banking systems are now much healthier and the structural reforms implemented over the last three years are already bringing results.

Moreover, the institutional architecture of the eurozone is now more solid than it used to be: there is a bailout fund (European Stability Mechanism - ESM), a banking union (although still incomplete) and the possibility of activating the Outright Monetary Transactions program (OMT), the European Central Bank's monetary bazooka, which recently overcame its last legal constraints.

"If Greece exits, new vulnerabilities will emerge, and there is no certainty other weak southern periphery nations will be protected."

More importantly: until September 2016, the ECB has committed to continue buying sovereign bonds through its Quantitative Easing program. QE has so far contributed to breaking the correlation between sovereign bond yields in the periphery. Now, despite on-going instability in Greece, Spain and Portugal are borrowing at very low interest rates.

But are all these sovereign backstops enough to protect the eurozone from contagion if Greece exits? The truth is that we can't be sure. A necessary condition for a monetary union to work is that there is a credible commitment as regards to the irreversibility of the union. For that reason, the word "irreversibility" is a key word in the treaties, reproduced all over. The "irreversibility" idea is also the reason why there is no actual legal base for exiting the eurozone.

If there were doubts about the irreversibility of the union, the euro would become like a non-credible system of fixed exchange rates; one that any country can actually leave, devalue and even consider returning to.

"Many European leaders are convinced that the costs of keeping Greece in will be actually larger than the costs of letting it go."

If that's the case, then as soon as there are doubts about debt sustainability in one or another country (for instance, Portugal, with a debt to GDP ratio of 125 percent) or over the political compromise of a government to commit to the fiscal rules of the union (Podemos in Spain, for instance), investors will have incentives to bet against that country. This, in turn, may activate a self-fulfilling speculative wave: risk premiums go up, interest bills become more expensive, the solvency of a given country is put into question and you are back in a sovereign crisis that ends either with a bailout or with exit.

Yes, the eurozone is now better equipped to respond to these speculative waves. And the Eurogroup has said that it will do "whatever it takes" to keep the stability of the union. However, some of these mechanisms are likely to face some design and political constraints. First, QE may prove insufficient, as it is not designed to deal with speculative crises (it's designed to fight low inflation). The ECB needs to buy bonds according to the capital contribution of each country to the bank, so if it were to increase their purchases, it would be buying large amounts of (very safe) German bonds and probably not enough Italian or Spanish bonds.

The second weapon would be to activate OMT and exercise its condition as actual lender of last resort for the eurozone. The problem, in this case, is political. For OMT to be activated, the benefited country needs to ask for a bailout from the ESM. Ahead of elections this autumn in Portugal and Spain, this is politically inconceivable. These countries will be facing very tight elections and a bailout would feed further support for populist forces, such as Podemos in Spain, which would then be competing to win.

"Although the eurozone is better equipped than it was in the past, it is still a highly imperfect monetary union."

A third option for the eurozone would be to promise a significant push in fiscal and financial integration. However, taxpayers in the north are tired of footing the bills, populism is still high and there is now no political appetite for further fiscal transfers or more risk-sharing at the eurozone level. Moreover, further fiscal integration would involve a change in the treaties, something unthinkable now.

Although the eurozone is better equipped than it was in the past, it is still a highly imperfect monetary union. In fact, if Greece exits, new vulnerabilities will emerge, and there is no certainty other weak southern periphery nations will be protected. This may add to the many reasons for the two parties to reach an agreement this week, allowing Greece to remain in the eurozone. The alternative could be the beginning of the end of the euro.

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Greece Votes 'No'