How might Greece leave the euro?

By Kabir Chibber

Business reporter, BBC News

Greece's latest woes have raised something that was previously unthinkable - the possibility of the Greek people rejecting the euro.

Prime Minister George Papandreou has said that rejection of the bailout would mean an exit from the euro. And the exasperated French leader, Nicolas Sarkozy, told Greeks: "Abide by the eurozone rules or leave."

So, for the first time, the subject of a country leaving the eurozone has been raised at the highest levels of the 27-member European Union.

With Greece unable to devalue its currency, the country is hobbled with crippling debt payments it can't afford.

Many economists (and Greek people taking to violent protests) think leaving the euro is the best way to get out of this mess.

So how would leaving the euro work?

New old currency

If Greece were to act unilaterally and just do it, the so-called "nuclear option" involves introducing a new currency - the new drachma - and letting supply and demand do what it does.

In this case, probably more supply than demand.

"The new currency would fall through the floor and inflation would go through the roof," says Peter Dixon, an economist at Commerzbank.

It would be a legal minefield, as basic financial transactions such as mortgages would have to be redenominated. But that would not be the end of it.

"Living standards would be hit hard. It might seem like an attractive option, but the short-term costs are massive."

Wouldn't banks - who have already agreed to take a "haircut" of 50% - just accept the devalued new drachma-denominated debt?

"Well, no, because it may well halve in value again," Mr Dixon says.

The assets of banks inside Greece and those outside holding Greek debt would be devalued. And of course, they would not be able to borrow commercially.

Greece would probably have to impose capital controls to prevent all the money leaving, much as Malaysia did in 1998 after the Asian financial crisis.

So in the best-case scenario, Greece would have no buying power, everything would be extremely expensive and it would also be broke.

Lessons of the past

But the idea is that, with its currency so weak, Greece's economy would grow rapidly.

People often use Argentina as a comparison of such an outcome, which Nobel-prize winning economist Paul Krugman has said is "an imperfect parallel".

Argentina, which had its peso linked to the US dollar, defaulted on $102bn of debt during a financial crisis in 2001-02.

In 2005, the country persuaded 76% of creditors to accept a debt swap that reduced the value of their bond holdings by nearly two-thirds.

But Argentina had to go through years of pain, and at least had the advantage of its own currency. The mechanics of de-pegging were easier.

Greece has to start afresh.

One comparison is Iceland, which in 2008 had a run on its currency when its banks failed.

The Icelandic krona lost more than half its value in one summer. It quickly faced interest rates at 15%, and inflation at 14%.

But Mr Dixon suggests the closest recent parallel to a euro exit might well be the splitting of Czechoslovakia.

In February 1993, the Czechoslovak koruna was split into the Czech koruna and the Slovak koruna - at a par of one-to-one. (One version no longer exists; Slovakia adopted the euro in 2009.)

But in that scenario, as with the replacing all the major currencies of Western Europe with the euro, people had time to adjust to the concept of a new currency.

"You had a long period of time to get used to the single currency," Mr Dixon says. "You're not going to to get it the other way around.

Treaty of good-bye

One major issue is that there simply is no mechanism to leave the euro.

It was never envisaged by the bright-eyed politicians who created the impetus for the currency, which debuted in 1999.

"The treaties indeed confirm what we have been saying here: the treaty doesn't foresee an exit from the eurozone without exiting the EU," said a European Commission spokeswoman on Thursday.

The treaties she is referring to are the Maastricht treaty from 1992, which led to the creation of the euro, and its successor, the Lisbon treaty in 2007.

So under its current obligations, for Greece to exit the euro, it would have to leave the EU. This option was only added in Article 50 of the Lisbon treaty.

Leaving is straightforward; it involves a member state notifying the European Council - that is, the heads of state of the EU - that it wants to go.

The Council then agrees the terms of the exit via a qualified majority.

Would leaving the EU be the end of the world for Greece? Probably not.

The key part of Article 50 involves "setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union".

Iceland, Liechtenstein and Norway all do fine and they are not in the EU. They are part of the European Economic Area, meaning they get access to the single market.

Switzerland is not even a member of this organisation, and it trades with the EU with few problems - the odd tax exile aside.

The EU could then bail out Greece at a lower exchange rate, even.

But again, the chaos of going from inside the EU to a country outside of it but still slap bang in the centre of Europe could possibly be even worse than what it is going through right now.

"What happens then is that cure ends up being worse than the disease," Mr Dixon says.

And the question would then become whether a queue would form at the door to leave the EU.

Would other bailed-out nations say enough is enough and join Greece? Would we then get the new punt? The new escudo? The new lira?