Should Busted Greece Stay In Euro Zone?

The Wall Street Journal

Should they stay or should they go? Now that it's (almost) all right to admit that Greece is insolvent, the question can now be asked: When should it default, and should it stay inside the euro zone or not?

The first question is a lot easier than the second. An imminent default, rumored by some on Monday, does nobody any good. The Greek government still has a primary deficit, and can't afford to repudiate its debts while it still can't cover its outlays with tax revenues. It also has no guarantee that the European Central Bank would continue to lend against defaulted Greek debt, and would have to reckon with the risk of its banking system collapsing instantly as a result.

For the euro zone, meanwhile, the imperative has been to postpone a Greek default until Ireland and Portugal could show the rest of the world that they really are different, and that Greece really is the only insolvent country in the region. For the other two countries to save themselves by their own exertions would be the best possible answer to contagion, and a vindication of the strategy of austerity-in-return-for-support.

The creditors could, just, afford to take the risk of forcing Greece to default now, if it weren't for the fact that Spain and Italy have joined the ranks of the invalids, and it doesn't seem tactically sensible to invite speculation on an Italian default right now.

For all of those reasons, it seems likely that the two parties will find their way to some kind of compromise that allows another €8 billion ($10.9 billion) of aid to be disbursed in October, just before the Greek government runs out of money. That will buy another three months for the rest of the problem countries, in which time the European Financial Stability Facility will also become fully operational as lender of last resort.

But that the situation is unsustainable is clear to everyone, and protests to the contrary from Athens, Berln and Brussels are audibly more and more faint-hearted. The question is not whether Europe should plan for a default, but what kind of default it should plan for.

Pace Nouriel Roubini and others, an exit from the euro zone and the re-introduction of the drachma is not the way to go. In the absence of a legal framework for such a step, a Greece that had defaulted, devalued and struck out on its own would not find that, with one bound, it was free. It would run straight into a hideous and paralyzing storm of lawsuits over who had the right to be repaid in euros and who got drachmas instead.

Advocates of a euro-zone exit argue that domestic liabilities should be repaid in new currency and foreign ones in euros. That may just be legally enforceable in a single market which supposedly guarantees non-discrimination within the whole European Union (although I doubt it). However, even if applied, it would reward all those—generally better off and more sophisticated Greeks—who have already taken their money out of the country. It would complete the impoverishment of one half of Greek society to the benefit of the other. Even in a world where there are only unfair solutions left, this would be an injustice with potentially disastrous consequences.

The other gigantic obstacle to Greece's leaving the euro zone is the fact that more than half of its debt is in the hands of official creditors. The International Monetary Fund has already lent €17 billion and euro-zone states €35 billion. In addition, there is the €50 billion or so that the European Central Bank has bought in Greek bonds, and the €96 billion it holds as collateral in respect of loans to Greek banks (plus another €15 billion in emergency lending assistance from the Bank of Greece).

That is almost €200 billion out of a total of €350 billion. In fact, it is well over €200 billion, as the ECB has not only bought most of its bonds well below face value, it also applies a hefty discount when it lends against Greek collateral.

The German government's council of economic advisers estimates that Greece needs its debt cut in half to be sustainable. As such, if Greece wants to seek its salvation outside of the euro zone, it will end up paying its remaining private-sector creditors next to nothing. The notion that it could soon start borrowing again after that is fanciful.

If, however, it stays within the euro zone, and continues to cooperate with Frankfurt in particular, then the outlook for finessing debt relief is far better. The EFSF can reimburse the ECB at cost for its portfolio of bonds held outright; it can exchange Greek banks' holdings of sovereign debt for its own at a discount. That would crystallize some awful losses for the banks, but funds would be available for recapitalization, and, more importantly, the ECB would have no trouble accepting the new collateral.

It's an open question as to whether Greece would be worse ruled by Greek bureaucrats or by EU ones for the next 10 years, but the technicalities of insolvency, at least, are likely to be more easily and constructively managed within the euro zone.

Write to Geoffrey T. Smith at geoffrey.smith@dowjones.com