Choices after the Greferendum

By Zsolt Darvas and Guntram Wolff

Is there a hard budget constraint option while keeping Greece inside the euro area?

On Sunday, with a sizeable majority, the Greek people voted down the proposals of the country’s official lenders. What’s next? We see three main options and will describe the pros and cons of each in more detail:

  • Grexit
  • A new financial assistance programme for Greece
  • Default or debt write-down inside the euro area coupled with external bank support and control

The choice will ultimately be political and we do not wish to speculate about the probabilities of these scenarios. However, a lot of trust was eroded over the last six months, which could make finding an appropriate solution very difficult. Instead of discussing politics, we want to discuss the economic implications of these three scenarios and their advantages and disadvantages.

One option is Grexit. There is no legal way for a country to leave the euro area, nor is there a way to expel a country from the euro area. However, economic necessity could make this necessary, which could lead to a de facto exit and ultimately result in a change in the EU Treaty to make exit legally possible. The key issue here is what happens to banks. If banks run out of cash, people’s cash reserves may run out too and they will find it difficult to buy basic goods such as food. Companies will find it difficult to pay their suppliers, which could increase corporate bankruptcies further. Sooner or later imports will stop (as importers will be unable to pay), which would further disrupt the economy and hurt people. Tax revenues will collapse and the government will not be able to pay wages and pensions. A new means of payment will have to be introduced to keep the economy going.

In our assessment, Grexit would lead to the largest financial losses for creditors, as most of the official financial assistance as well as the entire ECB and Bank of Greece’ Emergency Liquidity Assistance (ELA) liquidity would probably be lost. In addition, a Grexit might increase future financial stability risks to the euro area whenever another euro-area country comes under pressure from the markets. The benefits of Grexit for Greece in terms of regaining competitiveness and increasing employment may be less significant than some commentators like Paul Krugman or Hans-Werner Sinn argue. In fact, we have argued (here and here) that the reason for weak Greek export performance was not high wages, but other factors such as rigid product markets, the complexity of regulatory procedures, weak institutions, a political system that prevents real change and guarantees the privileges of the few, etc.

An argument often voiced in favour of Grexit is that it would establish the principle that countries cannot break the rules and afterwards be rewarded with unconditional debt relief. A problem with this argument, however, is that it puts all the blame on Greece for the failure of the financial adjustment programmes. In our view the responsibility has to be shared between Greece and its lenders, and Greece has paid a price in terms of employment and income. Another argument favouring Grexit would be that Greece will not be able to extract any resources from the rest of the euro area in the future. Grexit would thus be a clear break, but a costly one with several unknown consequences. It would certainly leave the current European leadership quite a political legacy.

A second option is a new financial assistance programme for Greece. In fact, the Greek government submitted a letter to euro-area partners on 30 June requesting a new financial assistance programme to repay the ECB and the IMF, yet trust has eroded so much that the willingness of euro-area partners to lend new money to Greece is severely reduced.

People celebrating the win of "NO" in the Greek Referndum, Syntagma square, Athens, Greece. (Photo: Courtesy of WikiCommons)
People celebrating the win of “NO” in the Greek Referndum, Syntagma square, Athens, Greece. (Photo: Courtesy of WikiCommons)

The outcome of a new financial assistance programme would largely depend on its design. It could lead to growth: indeed, while the adjustment of other EU countries with some similarities to Greece (such as Portugal, Spain and the Baltics) was painful, all of these countries returned to growth and job creation. Even Greece started to grow in 2014 and new jobs were created. Any new agreement may focus on growth-enhancing structural reforms and limiting corruption and tax evasion, while offering a lower fiscal adjustment demand.

The question of dealing with the debt level would remain on the table. We believe that one should agree on a deal that would index debt to GDP. When nominal GDP growth is high, there is no reason to provide any debt relief. When nominal GDP growth is very low, debt relief will be inevitable under any scenario. Such a deal could bring important planning certainty and would make investment and growth more likely.

More importantly, Greece would continue to be subject to a relatively tight budget constraint and programme monitoring. Yet the past five years have demonstrated that cooperation between Greece and its official lenders is extremely difficult. A new financial assistance programme may bring the spectre of another series of disappointments at both sides of the table.

A third option is a default or debt write-down coupled with bank support to keep Greece in the euro area. Similarly to the suggestion of Willem Buiter, euro-area partners may conclude that there is no way to find an agreement that Greece will consistently honour, yet they may prefer to keep Greece inside the euro area. For the latter to happen, Greek banks would need to be kept afloat. This in turn will require support from the rest of the euro area in one form or another. The most likely form of that support would be direct recapitalisation by the European Stability mechanism (ESM), leading to ESM ownership of the Greek banks. The ECB should then continue to provide liquidity to banks and capital controls would be gradually lifted.

The key question in this third scenario is whether one can enforce a hard budget constraint on Greece. This could in principle be achieved by two means. First, Greek banks should be prohibited to finance the government, both under ESM ownership and after the ESM has sold its capital injections in later years. Second, any new financial assistance programme for Greece should be strictly excluded ex ante. Thus the Greek government would need to convince markets to finance any potential deficit under these circumstances. Even if any future Greek government were to default on its market, it would not impact the Greek banking sector directly. In practice, it may be more difficult to enforce a hard budget constraint in this scenario, especially if the Greek government chose to circumvent the rules by imposing losses on the banks through other legislation (e.g. changes in insolvency laws).

The absence of a financial assistance programme would imply that micro-managing the Greek crisis by official creditors is over. This would therefore free Greece and its official creditors from the difficult and apparently unproductive day-to-day cooperation. It would give the freedom to the Greek government and parliament to design and implement their desired policies (at least within the EU’s economic governance framework). However, so far we have not yet seen a sufficient proposal from the Greek government to tackle the major weaknesses of the Greek economy, such as tax evasion, corruption, an ineffective legal system and insufficient competition in product markets, so it is not sure how wisely this freedom would be used. For euro-area partners, this solution would require a complete change in their approach to managing sovereign distresses in the euro area, in addition major losses on their lending to Greece and new support to Greek banks.

In our assessment all three options are problematic. Being in a monetary union with a partner that you do not trust is ultimately unsustainable. But Grexit would be a collective political failure with unknown financial, economic and social risks. A new programme will mean negotiations with Greece for many more years. Meanwhile, a large-scale debt write-down and direct European recapitalisation of banks would be an immense change in the euro-area sovereign distress framework, with wide-ranging consequences including a possible loss of credibility for the no-bail-out clause. Choosing the least political evil will be the main challenge for today’s Eurogroup meeting and Euro Summit. History teaches us that monetary unions can break up, that countries can go bust and that countries can free-ride on others. However, history also teaches us that monetary unions are typically only sustainable if its members face hard budget constraints – enforcing these constraints is a key challenge in the historical creation of monetary unions.

Zsolt Darvas is a Visiting Fellow at Bruegel since September 2008 who continued his work as a Research Fellow from January 2009, before being appointed Senior Fellow on September 2013. He is also Research Fellow at the Institute of Economics of the Hungarian Academy of Sciences and Associate Professor at the Corvinus University of Budapest. 

Guntram Wolff is the Director of Bruegel since June 2013. His research focuses on the European economy and governance, on fiscal and monetary policy and global finance. He regularily testifies to the European Finance Ministers’ ECOFIN meeting, the European Parliament, the German Parliament (Bundestag) and the French Parliament (Assemblée Nationale) and is a member of the French prime minister’s Conseil d’Analyse Economique.


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Bruegel is an independent European think tank specializing in economics. Established in 2005, Bruegel is independent and non-doctrinal. Its mission is to improve the quality of economic policy with open and fact-based research, analysis and debate. Bruegel was ranked first in 2012 and second in 2013 among all international economic policy think tanks worldwide by the Think Tanks and Civil Societies Program at the University of Pennsylvania. Among all think tanks worldwide, it was ranked eighth in 2012 and sixth in 2013.

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