Retreat from Grexit

The euro region is stepping back from the abyss. After weeks of media reports claiming that German officials were ready to accept losing Greece from the euro, saner thinking seems to have prevailed — as the drastic drop in Greek bond yields today demonstrates. The whole episode is a timely reminder, though, that while European Union law describes the euro as irrevocable, investors aren’t so sure about its permanence.

A more conciliatory tone from Alexis Tsipras, the most likely winner of the Greek election on Jan. 25, is helping make everyone more realistic. Over the weekend, he pledged to maintain the country’s euro membership and to honor Greece’s debt obligations. The nation is to repay more than 5.6 billion euros in March, up from the 1.4 billion euros it needs to pay this month and the 2.8 billion euros that come due in in February, according to Bloomberg data.

Comments from German officials have also soothed investors. Volker Kauder, the chief whip for Chancellor Angela Merkel’s Christian Democrats, told Focus magazine that talk of Greece exiting the euro was “nonsense,” and would prompt speculation about other countries leaving. The less sanguine Germany seems about a break-up of the euro, the better.

The rest of the euro region is less financially exposed to Greece than it was in 2009, when a newly elected Greek government confessed that the nation had for years been less than truthful about its budget deficit. The private sector now owns only about a fifth of Greek government debts, following the country’s bailout by the European Union, the European Central Bank and the International Monetary Fund. Nevertheless, Greece leaving the euro would still be a disaster for the common currency project.

This is because, once one country departs and proves that euro membership can go the way of all flesh, traders won’t be able to resist picking off the currency’s weaker members by shorting their bonds and driving their borrowing costs through the roof. While a Greek revival of the drachma would have zero implications for a return of the escudo, the peseta or the lire, that’s no deterrent to a hedge-fund that smells profit, no matter what logic, economics or politics might suggest.

While Greece’s borrowing costs are dropping today, with three-year yields down to less than 12 percent, after jumping above 16 percent last week, the banking system remains vulnerable to a run. Deposits, which plummeted at the start of the crisis and haven’t really recovered, dropped by about 3 billion euros in December:

The Greek central bank said yesterday that the outflow of deposits is “completely under control.” Those 2009 withdrawals, though, show that money can flee quickly when depositors feel threatened.

Rapprochement between EU leaders and the new Greek government will require both sides to cede ground. Tsipras is understandably exploiting Greece’s austerity fatigue for his own political ends, but he shouldn’t make promises he can’t afford. The EU, for its part, has to acknowledge that it needs to do more to boost growth and create jobs, and not just in Greece. Perversely, the Greek election could end up doing the euro region a favor by jolting Germany out of its fiscal intransigence, thus ushering in more growth-friendly policies to accompany the European Central Bank’s increasingly loose monetary stance.