Incredible Threats?

Yesterday, Yanis Varoufakis presented an article over his concerns about the OMT (Outright Monetary Transactions) program announced by Mario Draghi almost two weeks ago. In the article, Yanis, after depicting the arguments in game theory style, states that if Mario Monti decides to take up Draghi's offer for OMT, then the former would be better off by not enforcing reforms and austerity measures in Italy, because the threat that Draghi will stop OMT operations in incredible. In essence, Draghi will be caught between a rock and a hard place.

Yanis states that it would be disastrous for Draghi to back out once he has agreed to fund Italy (or any other country for that matter) since the result would be that Italy would most likely exit the euro. However, I think that in his analysis, Yanis fails to state three points:
1. Money will not be given as a lump sum as soon as the agreement is signed. What should take place is an instalment-based assistance just like in the case of Greece.
2. Economic theory (and game theory) states that rational people will choose what is best for themselves under certain circumstances. However, behavioral economists have proven that people are not at all like the rational beasts economists perceive them to be. (Paradoxically, economists themselves are not as rational as they think they are)
3. The consequences for Italy if the country exits the Eurozone.

If game theory was right, it would mean that the Greek government would have an incentive to exit the Eurozone and declare bankruptcy as soon as

Grexit is not an option

Yesterday, Antonis Samaras, Greece's Prime Minister stated that a return to drachma would mean another 5 years of recession for his country, unemployment reaching 40% and could potentially be the end of democracy for the nation. What Samaras did not mention, however, were the effects this might have on every other European country.

First of all, a large Europe-wide economic downturn would occur, given that banks which still have money in Greek bonds will find out that their investments have vanished into thin air. This would mean that governments may have to bail-out several banking institutions. In countries like Spain, Italy, Portugal and Cyprus this would break them down, and it might even be a severe blow in "strong" nations like Germany (Deutsche Bank's balance sheet is about 80% of Germany's GDP. You may imagine what would happen if another 1 or 2 German banks face problems). This would lead to countries asking for financial assistance from the ECB/EFSF/ESM or basically anyone who is willing to lend them. As individual investors would be too terrified to lend, EU officials will face two options:

(i) let all countries which cannot help themselves fail

(ii) bail-out all EU nations in need for help

If option (i) is chosen, then what would happen next would be the death of both the European Union as well as the Euro (for consequences around the world if this occurs read The Effects of a Euro Collapse). Option (ii) would mean that the EU and the Euro will survive, but with a longer and harder recession than the one Greece is now facing. Thinking backwards, if the EU officials enjoy their jobs and were to choose option (ii) why not keep bailing-out Greece, especially now that the worse is gone and all they ask is time (fine maybe and a couple of billion as well)?

A recent poll in Finland indicated that 66% of Finns want their country to avoid shouldering more financial responsibility, even if it would save the euro. Hmm since when does asking people with no apparent knowledge on economics what to do has become a good policy? Of course the Finns have their Grexit scenarios. Every country should. What they should not be thinking is exiting the euro. If the situation is bad now, what do you think would happen if a country changes currency? First of all inflation would hit them so hard, it would take years before they can be competitive again.

What the Finns are saying is that they do not want to pay for other peoples' messes. True, why should they? Nobody would want that. That is why the ECB should make a direct intervention to prevent fragile economies from breaking down. ECB money is neither Finnish, nor German nor Greek. It's ECB money. It's EU money. Money that should have been in the system from before and not wait until now. At least now is still not too late.

The Effects of a Euro Collapse

Some believe that the destruction of the Eurozone, and as a consequence the collapse of the common currency, is eminent. Many actually look at this favorably as they believe that such a result would be beneficial to the world. I have read articles stating "why doesn't the Euro collapse to get over with this situation? We will deal with the consequences and then be better off". The problem is no one seems to understand what these consequences are. 

The following is an excerpt from a Financial Times article in 2011 (article can be found here):

"A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A full or comprehensive break-up, with the euro area splintering into a Greater Deutschmark zone and about 10 national currencies would create pandemonium. It would not be a planned, orderly, gradual unwinding of existing political, economic and legal commitments. Exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally and competitively weak member states, whose currencies would weaken dramatically and whose banks would fail. If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression."

Does this sound bad enough? The article states that a Greek exit could be manageable. It could be, only if the ECB decides to bail-out the EU countries which would be affected by that exit (That would be hmm... almost every country in the EU, even Germany). If the ECB decides that it would help the countries which would face disaster after a Grexit then why not help Greece directly and avoid such an outcome? The outcome of an Italian exit would be even worse given that it is the 8th largest economy in the world. You may only imagine what would happen if Germany were to exit.

The aftermath of an exit would occur not only to the Union but to the exiting country as well. For example, a Greek exit would mean that prices and wages in the country would fall rapidly, gaining a short-run competitive advantage which would be lost after inflationary powers settle on the country. As a result, the country would be poor, uncompetitive and with the additional disadvantage that no one would dare lend it because it that had just exited the EU. If Germany exits then the new German currency would suffer such an up-rise which would make all German products uncompetitive, leading the now booming German exports to a downward spiral.

In another article, a euro collapse is called as the "mother of all financial disaster". Robert Zoellick, the former president of the World Bank has stated that Europe may have a Lehman moment. (Just like the Lehman Brothers collapse in 2008, which triggered the worst recession in the world since the 1930's).

The worst part of all is that most of the consequences which may occur under a Euro collapse are still unknown. Germany is thought to be the state with the most sound economy in the EU now. However, German investors hold 550bn euros of sovereign bonds outside of Germany. What would happen if the euro collapsed? Most likely they would lose it all and the German government would have to bail them out. One may only imagine how many EU bonds are in the hands of non-European banks and other investors.

My simple conclusion agrees with this LSE article: It is better to do everything to save the euro than to let it fall apart.