Greece's Future Remains within EMU

The electoral outcome in Greece appears to be producing a fragmented parliament and will likely increase the platform for those parties that are more hostile to additional austerity and perhaps even the euro zone projected.

Nevertheless, we suspect much of the talk today about a Greek exit is exaggerated. The policy "prediction" web site, www.intrade.com shows a little less than a one in four chance of a country leaving the euro zone this year, rising to almost 49% next year. These odds are only slightly higher than prior to the weekend.

The main reason we expect Greece to stay in the union is that as bad as things are now, it will be worse out. It seems far too simple to think that a devaluation is all Greece needs. Its debt is now largely in official hands and its obligations to the IMF and ECB and EFSF for example will see be denominated in euros, whatever the national Greek currency is. The ECB alone holds about three quarters of Greece's debt. Moreover, Greece does not have the industrial capacity to take advantage of a weaker currency to significantly boost exports.

Can introducing a new currency for the sole purpose of devaluing it really work ? Would Greek shop keepers and producers accept it or would the Greek economy remain euro-ized ? The economic fall out would likely produce weaker growth and higher inflation and more social strife.

Every day that the Greece struggles to cobble together a government, the greater the pressure on it to present 11.6 bln euro savings plan for 2013-2014. Under the conditions of the second aid package, this is due by the end of next month.

We have also argued that Greece's geo-strategic significance should also be recognized. If it were to leave EMU, and would be in need of hard currency, Russia (and China) appear quite willing to pick up a port or basing rights in the NATO member. China has already been granted a long-term lease to a large port.

If Greece does leave the union, some expect the euro to rally. We are more skeptical. Greece is a symptom of the problems EMU faces and is not really a cause. The problem has to do with the lack of greater integration, the lack of institutional capacity, the fiscal straight jackets, the reluctance of the surplus countries to tolerate higher inflation or less austerity.

If Greece were to leave, pressure on Portugal and others in the periphery, would likely grow, not diminish. It would lead to new divisions in Europe.   Some compromise on the pace of austerity in Greece and some relaxation of fiscal targets may be seen.  After all, Spain and Italy have already acknowledged that this year's initial target will not be met. 

Spain and Italy's challenges would not be diminished one iota by the exodus of Greece, for example. The slipper slope knows no obvious end as by a range of macro-economic considerations, France has more in common with the periphery than with the core.