Facing a Teetering Greece, Europe Plans for the Worst

...A few months without foreign aid and E.C.B. lending, Mr. Kirkegaard said, would be enough to convince the Greek people that the conditions imposed by foreign lenders would be the lesser evil....

The New York Times

FRANKFURT — To listen to European leaders lately, the debate about Greece’s exit from the euro zone is increasingly moving from “if” to “how.”

Policy makers and many economists continue to regard Greece’s departure as a doomsday situation that must be avoided at all costs, and there is clearly an element of brinkmanship in talk of a “Grexit.” But it has become clear in recent days that secret contingency planning has begun in case events spin out of control.

The German Bundesbank all but admitted as much on Wednesday when it said in a report that Greece’s exit would be difficult, but possible “with careful crisis management.” The cautious, data-driven economists at Germany’s central bank would not have made that statement without studying the issue thoroughly.

Jean-Claude Juncker, the prime minister of Luxembourg, said early Thursday in Brussels that keeping Greece in the euro zone was still the preferred plan. But he added, “We need to be armed for all eventualities.”

No one thinks that amputating Greece from the euro would be easy. Some of the official murmurs about doing so are clearly aimed at Greek voters before elections next month, which European leaders are trying to cast as a referendum on euro membership.

Still, predictions of a Greek exit no longer seem like the musings of a few euro-skeptic economists. Even if no one really wants Greece to leave, there is a risk that elections there o out of June 17 could produce a government that is unwilling or unable to meet the terms set by the European Union and the International Monetary Fund in return for aid. In that event, Greece would run out of cash by the end of the year, economists at Citigroup said in a report this week, forcing the country to seek refuge in its own currency. Some think that could happen even sooner.

“As much as policy makers claim this won’t and can’t happen, there must be planning going on,” said Jennifer McKeown, senior European economist at Capital Economics, a consultancy in London.

Can a Greek secession be managed?

“I think there is a chance it could be contained,” Ms. McKeown said. But she added she was not confident that European leaders would make the right decisions.

As handpicked teams of crack policy makers presumably meet in soundproof chambers in the bowels of central banks and government ministries to plan for a euro zone rupture, they are probably contemplating how to contain two overwhelming risks.

One is that Greece’s exit would unleash social chaos in Greece. The other is that it would provoke a financial crisis in the rest of Europe, and perhaps the world, the way the collapse of Lehman Brothers did in 2008.

Preparations would have to be made in secret, say economists who have studied the issue, then executed with lightning speed over a weekend, when banks were closed.

One serious problem is how Greek officials could print new currency, a process that would take weeks or months, without word leaking out and provoking a bank run.

Greece might not need to print new drachmas right away, economists at Capital Economics contended in a paper this year. Most transactions these days are electronic anyway, they said. For small everyday transactions, Greeks could use the euro until new notes were printed.

Charles B. Blankart, a professor at Humboldt University in Berlin, has argued that Greeks should be allowed to keep their savings in euros during a transition period, to remove the incentive for them to storm the A.T.M.’s in Athens and Salonika.

Greece would also have to contend with a steep devaluation in the reintroduced drachma. To some extent, devaluation is the whole point. It would help Greek wages fall in relation to the rest of the world so that the country would become competitive in export markets. A weaker currency would achieve the wage cuts, estimated at 40 percent, overnight instead of over years as is likely if Greece stays in the euro.

But there would also be grave side effects. Economists at Citigroup estimate that the new drachma would plunge 60 percent against the euro as soon as currency markets opened. The prices of imported oil and other commodities would soar in drachmas, potentially canceling out the benefits of devaluation.

To prevent hyperinflation, the Greek central bank would have to pursue a tight monetary policy and resist political pressure to print too much money. The government would also have to become fiscally responsible.

Given Greek political leaders’ record so far, that seems far-fetched. But they may not have a choice. The country could probably not sell debt to foreign investors for years, forcing the government to live within its means.

Even in the unlikely event that Greece did everything right, the country would continue to need international support. Greece’s banks, stripped of euros to meet international obligations and cut off from international capital markets, would probably collapse, requiring bailouts financed by the European Union.

That means a Greece outside the euro would remain an enormous financial burden on European taxpayers. But the European Union would have an interest in preventing a complete economic collapse in Greece, which could usher in radical left-wing or right-wing governments or a breakdown in law and order.

Some analysts argue that an exit by Greece might shock European leaders into making changes they should have introduced before they created a common currency, like establishing a powerful pan-European bank regulator and other trappings of a federal system.

To prevent bank runs in Portugal, Spain and perhaps other countries, European leaders might finally create a deposit guarantee similar to the Federal Deposit Insurance Corporation in the United States.

Citigroup economists, who forecast the chances of a Greek exit within two years at 50 percent to 75 percent, said the European Central Bank would also have to move more aggressively, cutting interest rates and providing a flood of liquidity to the banks.

Because of the mind-boggling risks, Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, put forth a third possibility, in the event that Greece refuses to honor the loan agreement and its lenders cut off aid.

Instead of formally leaving the euro zone, which is uncharted legal ground, Greece would become like Montenegro, using the euro without meeting the requirements of euro zone membership. A few months without foreign aid and E.C.B. lending, Mr. Kirkegaard said, would be enough to convince the Greek people that the conditions imposed by foreign lenders would be the lesser evil.

“They are going to be Montenegro for a few months, and then they are going to find a way to re-engage with the euro area,” Mr. Kirkegaard said. “The chaos that will have happened will serve the political purposes of Germany and others and show the consequences of leaving the euro, which are pretty serious.”