WILL EUROPE KICK GREECE OUT OF THE EUROZONE?

Sarah,

Last week I summarized the financial crisis in Europe.  Now there is a chance Europe will have to kick Greece off of the Euro.  This week, The Economist gave a great description of what that might entail.  I don’t completely understand all of the economic complexity, but here is my general understanding.

Quick Background:

17 countries use the Euro as currency.  5 of those countries (Spain, Ireland, Portugal, Greece, and Cyprus) are really struggling.  For the last two years or so, Germany and the richer European countries have been lending money to the struggling countries but nothing seems to be getting better.  The rich countries are tired of lending money and the struggling countries are tired of making the budget cuts that their lenders demand. 

Of the struggling countries, Greece is doing the worst.  Their budget is a mess, attempts to cut government have led to constant rioting, and their politics have turned troublingly extreme.(racist)  So why not just kick them out?

Here is what might happen:

Currently Greece is on the Euro.  If they get “kicked out” they will convert all their Euros to Greek Drachmas.

After the transition, the value of the Drachma will drop considerably.  This drop in value should make Greece more competitive. (The reasons for this are complicated, but think about it like this: would you rather visit Greece when your two dollars gets you one Euro or when one dollar gets you 100 drachmas?)

Once Greece is outside the Euro, the richer European countries will be able to stop lending as much money to Greece.

The expulsion would also serve as a lesson to other European countries that they need to get their stuff together or they too will be booted.

So What’s The Hold Up?

There are a lot of reasons this could go terribly wrong.

First, there are some practical concerns.  The expulsion would be an enormous operation.  If news of the transition leaked before it could be effectuated, investors would scramble to take all of their money out of Greece.

Second, Europe has already lent Greece billions.  If Greece goes off the Euro, Europe’s chances of being repaid go down dramatically. Europe would basically just have to take the hit.

Third, the expulsion could cause a panic.  Right now, people are lending to Spain because they do not believe Spain will be expelled from the Euro and they believe they will be repaid.  An expulsion of Greece would send a message that other countries can in fact be kicked off the Euro.  When investors realize this, they may stop lending to Spain at a time when Spain needs the money the most.  If nothing else, the cost of borrowing will increase dramatically for all the struggling countries.  Further, investors may start pulling their money out of the other troubled countries which could cause a run on the banks.

Fourth, this could cause a political rift between Greece and the rest of Europe.

Bottom line: Either way, Europe is not getting better anytime soon.

source: The Economist, "Breaking up the Euro Zone" August 11th, 2012