Grexit doesn't have to mean the end of the Euro
Erkki Tuomioja has been providing some interesting insights into Eurozone thinking recently. Firstly, there was the revelation from Finland's foreign minister that his country is planning for a possible Euro break-up – comment swiftly retracted. And secondly that a Greek exit from the Euro is very likely.
Greece looks like a lost cause to many Eurozone leaders – it's economy is uncompetitive and imploding under the weight of debt and austerity. In theory reintroducing the Drachma would see the currency depreciate to a level where Greece would be competitive. The problem with Grexit is that it would set a precedent and the markets would swiftly anticipate the next exit candidate – cue in Spain and Italy, the latter is believed too big to leave. Hence, other Eurozone leaders dismiss Grexit talk.
Losing Greece while saving the Euro would require the European Central Bank to be in a position to act like a normal central bank. Contagion would quickly show up in soaring yields of Spanish and Italian government bonds. But if the ECB made it clear that it is prepared to buy unlimited volumes of this debt to support the market and even set low target yields there's a very good chance contagion would be stopped dead in its tracks.
Ultimately, ECB action would also have to be accompanied by a credible plan to boost Eurozone economic growth, which could involve easing austerity, deploying funds to distressed countries (fiscal transfers), economic reforms and refinancing the Eurozone's weakest banks.
Indeed, there is a precedent of sorts here – the European Exchange Rate Mechanism. The UK was ejected from it in 1992, but Italy, which was also under speculative attack, remained in the ERM partly because of political determination, but also because of concerted intervention by Europe's central banks including the Bundesbank. Of course there are many political hurdles for setting up this ideal scenario for Grexit and saving the Euro – not least German resistance to money printing. But if the Eurozone's leaders pulled it off, a Greek exit could even be seen as a positive for the Euro and trigger a rally across a range of risk currencies.