- Euro zone leaders have hardened their stance on Greece markedly, with allowing Greece to default and even leaving the euro now discussed as viable options as a way forward in the debt crisis. There may be two main reasons for that.
- First, the rhetoric about Greece's potential euro exit is partly aimed at ensuring that Greek leaders do not assume that they can expect endless support from the euro zone no matter what happens. In particular, euro zone leaders want stronger commitments that Greek politicians will continue to implement the fiscal austerity programme regardless of the outcome of the April general election.
- Second, there is now a stronger conviction among governments that a Greek default and even euro exit could be absorbed and that contagion to other highly indebted euro area countries could be prevented in such a case. This belief is based on the unprecedented liquidity support that the European Central Bank (ECB) is giving EU banks, and the reasonable progress achieved by Italy's technocratic government in dealing with the country's debt problems.
- This second point appears to be particularly popular among the most creditworthy sovereigns in the euro area, Germany, the Netherlands and Finland. Important voices within and outside government in these countries are increasingly in favour of allowing Greece to default and leave the euro as they do not see how Greece can become independent from euro zone financial support for the foreseeable future. These governments are concerned that their electorates will punish them at the next election if they do not get tougher on Greece.
- However, although the risk of contagion from Greece to the rest of the euro zone has indeed fallen during the past year (for example, thanks to ECB intervention, banks' own deleveraging policies, progress in Italy and Ireland) there are still major risks. Allowing Greece to default would still cause major losses among European banks and could raise fears among investors that Portugal could be next, thus raising the need for further bail-outs for Portugal, and potentially the other highly indebted countries too. Allowing Greece to exit the euro could have even more dramatic consequences. First, it would cause an even sharper economic depression in Greece (owing to a sharp rise in inflation, erosion of household savings etc.). Second, investors and households in other vulnerable countries may become increasingly worried about their euro savings and investments in those countries and could cause bank runs and capital flight. In such a scenario, the whole euro area may break up if euro zone governments and the ECB fail to build sufficient firewalls (the current rescue mechanisms look insufficient to protect the euro area).
