Greece after the referendum

Prime Minister George Papandreou?s call for a referendum on the new European Union bailout deal took almost everyone by surprise. Policymakers are holding emergency meetings, markets are falling and commentators are envisioning not just the departure of Greece from the euro area and possibly from the EU, but a collapse of the single currency as well.

The announcement has indeed come at an unexpected time. Conclusions at the October 26 summit were also incomplete, since the voluntary private sector involvement is unlikely to deliver sufficient debt reduction. But the new agreement and also the lower primary surplus target indicated in the leaked documents of the fifth review of the first program give at least a higher chance of success for achieving fiscal sustainability — even if a new round of writedowns could be envisioned down the road. And Greece has such huge weaknesses in structural indicators that with or without the EU deal the reforms must continue.

The referendum, if it does take place and delivers a ?no? response, may lead to an uncontrolled Greek default with wide-ranging consequences. Yet the referendum may not be held after all, and even if it is, it may deliver a ?yes? response — if the Greek people understand the real implications of their decision. While the question to be asked is not yet known, the referendum will not be about continued austerity, which is, according to lawyers, an issue on which the Greek Constitution does not allow a ballot. It will most likely be a more fundamental choice about the future of Greece in the euro area or even in the EU:

Are the Greek people ready to continue the program and suffer more, but with the hope of success at the end?

Or do they want to push their country into chaos with far worse social and economic consequences?

A ?no? to the first question above is equivalent to a ?yes? to the second. While with external political and financial support even a non-voluntary debt reduction could be manageable, an eventual ?no? at the referendum would put this support at risk and Greece would most likely remain on its own: Official lending from euro-area partners and the International Monetary Fund would be suspended, followed shortly by a government default. The country would stop servicing its public debt and would need to achieve an immediate balanced budget — in the absence of borrowing expenditures cannot exceed revenues. This would be overly difficult to achieve, even though the leaked document of the fifth review of the program projects a 1.4 percent of GDP primary surplus for 2012. But this projection is based on the assumption of no default.

In the event of a government default, the banking sector would suffer massive losses on Greek government bonds and, in the absence of external help for recapitalizing the banking sector, banks would default as well. But the banking misery is unlikely to end here. Instead, the already ongoing bank run could accelerate (even as soon as in the runup to the referendum), bringing the collapse of the banking system forward. The European Central Bank would be right to exclude the defaulted Greek bonds from its operations and due to the likely chaotic situation of the Greek banking system after the default, it may refuse to agree to the so-called ?exceptional liquidity assistance? that the Greek central bank may provide to the Greek banking system. All of this would culminate in a fully fledged banking crisis and possibly a breakdown of the payment system as well. Such a banking crisis would spill over into the real economy, leading to an even deeper recession, widespread corporate bankruptcies, higher unemployment and lower fiscal revenues — thereby requiring further significant fiscal austerity measures.

And the above scenario foresees Greece remaining in the euro area. But politics may come into play in this regard — even though there are no provisions in the EU Treaty for an exit from the euro, only for an exit from the EU. Seeing the call for the Greek referendum as an uncooperative political move by the Greek government (referendums on austerity are not being organized elsewhere) and the ?no? by the people of Greece to the external help, the political support for keeping Greece inside the euro may diminish. An exit would render bankrupt even more private borrowers. Analysts from UBS have recently concluded that a weak country leaving the euro area would lose about one half of its GDP in the first year — I think they are right. And there would be longer-term consequences as well, since the low credibility of the newly stand-alone Greek central bank would likely lead to much higher real interest rates as well as a period of high inflation, both of which are bad for growth.

There could be consequences for the rest of the euro area as well — and we already see some signs. Italy?s 10-year yield has risen to 6.3 percent per year due to the increased uncertainty about the Greek end-game and the future of the euro area in general. This interest rate level is certainly uncomfortable compared to the record-low German interest rate, but not something which is inherently unsustainable, even though some commentators argue that it is. But it may increase further and in the worst case a bank run could start in Italy as well, culminating in a sovereign and banking crisis, which could be too big to absorb.

The possibility that an uncontrolled default may occur in Greece should not come as a surprise to euro-area policymakers, and it is a pity that they have failed to prepare for such a collision. There is no more time to waste and they should at last find the right solutions to limit possible contagion, among which freeing euro-area banks from national capitals would be paramount. But the seemingly forgotten Eurobond project could also be revitalized, which would bring financial stability in the next few years and alleviate the need for unpopular official bailouts.

Therefore, while euro-area policymakers could do much more to safeguard the euro area, the choice for the Greek people is also clear: Go home from the streets and continue the badly needed structural and fiscal adjustment program, or push your country into chaos and possibly out of the euro and the EU. It will soon be decision time.

Zsolt Darvas is research fellow at the Brussels-based think tank Bruegel.