A Eurozone Without Greece

It’s time to think more seriously about this possibility.

The Wall Street Journal

By RICHARD BARWELL

April 1, 2015 3:48 p.m. ET

The 24-hour news cycle is causing a cacophony of speculation about Greece leaving the euro, the so-called Grexit. Amid all the arguments about whether Greece will or should exit, there has been a lot less thought given to what would happen if Greece does return to the drachma. It’s time to think more seriously about this possibility.

A Greek exit would have far-reaching consequences for the eurozone, weakening the ties that bind the single currency together in some respects, strengthening them in others. On balance the latter will probably dominate, reducing the chance that other countries leave. If Greece leaves the eurozone, it would create a number of precedents that would influence how people vote and politicians behave elsewhere in Europe.

If the Greek people choose to leave in a referendum, they will send a powerful signal that they, and not the central bankers, officials and politicians in Frankfurt, Brussels and Berlin hold the destiny of the euro in their hands. But if it’s the Greek politicians who make the decision to leave, based on an electoral mandate rather than a referendum, that could make voters elsewhere think twice before voting for antiausterity candidates.

There will be lessons for politicians about the dangers of brinkmanship, especially if a Grexit happens almost by accident. If the funding problems facing the government and the banks escalate out of control, capital controls would be triggered, making a vote on Greece’s future—whether by Parliamentary elections or a referendum—far more likely. Politicians in smaller economies might in future be more likely to cut a deal with creditors, and politicians in creditor countries might be more likely to offer better deals, including debt relief. After all, Greece would almost certainly unilaterally default on its debts when it leaves.

Meanwhile, a Grexit would resolve the uncertainty over how to leave the single currency. The euro wasn’t designed with an easily accessible escape hatch. If Greece does leave, it will establish a precedent, but not one that others may wish to emulate, since it might also have to leave the European Union too.

Most important of all, a Grexit might set an economic precedent. If the Greek economy should recover after leaving the eurozone, it would be much harder to convince others that they should stay.

However, a painful economic afterlife seems far more likely. The Greek economy would get caught in a pincer, with a sharp and sustained contraction in credit and an increase in uncertainty propelling the economy back into a deep recession. There would be a significant risk of further, lasting damage to the Greek economy through the destruction of jobs and companies.

Even the sharp depreciation in the currency would be a double-edged sword. There would be a painful squeeze on disposable income as imports become much more expensive. This would at least partly offset the boost to Greek exports, assuming companies elsewhere in the eurozone don’t reroute supply chains out of Greece to avoid invoices billed in drachma. Likewise, it is brave to assume that there would be an influx of foreign capital until the political and economic uncertainty has been resolved.

Greece would also be giving up the long-run benefits of euro membership, such as increased trade and competition, a more-efficient allocation of resources, a greater capacity to insure against risk that comes from unfettered access to European markets, and the greater stability that comes from delegating the conduct of economic policy to more effective institutions outside of Athens. The complexity of creating credible domestic-policy institutions in the aftermath of a Grexit shouldn’t be underestimated.

Beyond these near-term challenges, there are two important medium-term consequences to consider.

A post-Grexit eurozone would be more susceptible to the kind of speculative attack on the currency union that took place in 2012. Given a resumption of sovereign stress in smaller countries, investors would quickly start to demand sizeable compensation for the risk that they may not be paid in euros in a future break-up scenario. Spending would grind to a halt and capital would fly out of the countries concerned.

The European Central Bank’s most potent policy tool, its quantitative easing program, isn’t designed to deal with this problem, and the instrument that is—the Outright Monetary Transactions program to buy a small set of sovereign bonds in the secondary market—may not be big enough to stabilize markets in a future crisis. The OMT can only be used to save countries that commit to saving themselves by driving through reforms.

We should expect a political response to fight those forces threatening to pull the eurozone apart. A Grexit could ultimately bring the union closer together, with fiscal union and common debt issuance going hand in hand with binding and credible commitments on structural reforms helping to turn the eurozone into an optimal and far more stable currency area.

This is all moot if Greece’s leaders hammer out a deal with creditors and avert an exit from the eurozone. But prudent policy makers and investors should spend some time considering how they would answer some of the questions that a Grexit might raise.

Mr. Barwell is the senior European economist at Royal Bank of Scotland.