From PIGS to PIS: Here are three lessons to learn from a potential Grexit

Around five years ago, we heard that the European Union had developed porcine worries. The PIGS - Portugal, Italy, Greece and Spain - were seen as weak links in the union that could go bust due to living beyond their means. When Ireland was added to the fissile mix, the PIIGS got spelt with two “Is”. Well, the PIGS may soon be reduced to PIS, with Greece about to slip on the muck of fiscal failure. By the end of today (30 June), Greece will probably be in default to the IMF to the tune of €1.6 billion ($1.8 billion), and if a referendum called on 5 July to decide whether or not to accept the final bailout offer from the EU results is a “no”, then all hell could break loose. Greece will probably have to seek an exit from the eurozone and issue its own currency - the old drachma. [caption id=“attachment_2319026” align=“alignleft” width=“380”] Protests in Greece. Reuters[/caption] Basically, the choice before Greece is stark - it will suffer whether it stays in the eurozone or leaves. If it stays in, it will have to enforce further cuts in expenditures and social security entitlements and raise taxes. If it exits and repudiates part or most of its external debt, it will get no fresh loans from any bank. The process of exit itself will be prolonged and painful, as Greece will have to renegotiate with each of its creditors and the EU to remain in the community. It can offer to re-designate its euro debts in drachma, but this will inflate its debt even further - as the drachma will quote at a huge discount to the euro. The net results will be similar hardships for the Greeks - cuts in entitlements, increased taxes, higher import costs - but higher export possibilities and some flexibility is fiscal and monetary policy. For Greece, it’s heads she loses, tails she loses. Given that Greece is but a tiny economy, why does the world fear a Grexit? Answer: uncertainty. The world is unsure what Grexit will lead to as there has been absolutely no precedent of any country exiting an economic union earlier. So it is not clear if Greece’s exit will lead to more instability or less. For example, the markets could fear that some of the remaining PIS - and, possibly France - may also face a credit crunch as lenders worry about who could default next. Alternately, the EU could close ranks after Grexit and strengthen the fiscal union. We can’t know how the markets will react to Grexit. There are, however, several lessons to be learnt from a Grexit - regardless of whether it happens, or the crisis is papered over for now. First, common markets and common currencies need political commitments that involve ceding monetary sovereignty to common central banks and fiscal sovereignty to a supra-national political authority where the decisions are binding on member-states. EU had neither. While the European Central Bank ran a conservative monetary policy under German tutelage until Grexit loomed, fiscal discipline was loose and largely observed in the breach. Greece entered the euro by fudging its debt figures. Clearly, economic unions won’t work without stronger due diligence and intrusive real-time surveillance mechanisms for member-states. Second, members of economic unions have to agree on community-wide social safety nets and fiscal transfers. The primary logic of an economic union is to enhance the total incomes of all members through increased trade and a reduction of economic disparities between the richer and poorer states. This means tighter fiscal and monetary union has to be complemented by wealth transfers from rich to poor in the short term - failing which social tensions can only increase within the EU. The alternative is free labour movements across member countries so that wages can equalise. Neither happened within the EU consistently. Third, the stronger states have to follow policies that are supra-national and not national. In the EU, Germany became the most competitive economy and so benefited disproportionately from this. Logically, if the weaker eurozone nations (the PIIGS, specifically) were asked to cut their fiscal deficits, Germany should have run an expansionary policy to bankroll this effort. This would have helped the weaker members to sell more to Germany while reducing the competitive gaps within the eurozone. An economic union can only be as strong as its weakest link, which means the stronger ones have to display even more commitment to it than the weak. A Grexit will be a testimony not just to Greek failure, but also Germany’s.