Consider the following scenario. After a victory by the left-wing Syriza party, Greece’s new government announces that it wants to renegotiate the terms of its agreement with the International Monetary Fund and the European Union. German Chancellor Angela Merkel sticks to her guns and says that Greece must abide by the existing conditions.
Fearing that a financial collapse is imminent, Greek depositors rush for the exit. This time, the European Central Bank refuses to come to the rescue and Greek banks are starved of cash. The Greek government institutes capital controls and is ultimately forced to issue drachmas in order to supply domestic liquidity.
With Greece out of the eurozone, all eyes turn to Spain. Germany and others are at first adamant that they will do whatever it takes to prevent a similar bank run there. The Spanish government announces additional fiscal cuts and structural reforms. Bolstered by funds from the European Stability Mechanism, Spain remains financially afloat for several months.
But the Spanish economy continues to deteriorate and unemployment heads towards 30%. Violent protests against Prime Minister Mariano Rajoy’s austerity measures lead him to call for a referendum. His government fails to get the necessary support from voters and resigns, throwing the country into full-blown political chaos. Merkel cuts off further support for Spain, saying that hard-working German taxpayers have already done enough. A Spanish bank run, financial crash, and euro exit follow in short order.
As Greece goes to the polls on January 25th, we have come closer than ever to the second sentence of this dystopia becoming reality. The problem is not what Syriza demands: debt relief in the South, combined with demand expansion in the North, is necessary if the euro zone is to recover. The problem is the chain of events that could be unleashed if Germany and others mismanage the consequences of a Syriza victory.
In particular, Angela Merkel may well believe that the rest of the euro zone is now sufficiently insulated from the consequences of a Greek exit from the euro. And she may be right. But she may be wrong too. A Grexit would set a precedent, and markets may sense Spain’s future in the euro is no longer assured. Much will depend on the way the game will be played by all sides and on market psychology. Which means there is huge uncertainty about the outcome.