How the euro zone handles Greece will determine whether the single currency survives — and hence the future of the European Union as a whole. If a Greek exit from the euro zone is mishandled, contagion to the other struggling member-states could be uncontrollable, leading inexorably to the collapse of the euro.
However, if a Greek exit is accompanied by big institutional reforms, the currency union could still be saved. Indeed, a Greek departure could be positive for the euro zone if it freed up the political space needed for the German authorities to embrace such reforms.
Some policymakers believe that a Greek exit would be cathartic — that it would demonstrate to other struggling euro-zone economies the risks of backsliding on their fiscal targets or the terms of their bailout programs. The risk of contagion would be limited, as governments would have no choice but to knuckle down, which would reassure investors about the sustainability of their public finances. According to this view, the ejection of Greece would obviate the need for big institutional reforms of the currency union, such as debt mutualization or pan-euro zone bank protection.
There are a number of problems with this line of reasoning. First, it assumes that Greece and other hard-hit members of the euro zone could meet their fiscal targets if only they tried harder to do so. As such, it is an example of the flawed reasoning that is responsible for the crisis having spun out of control.
The assumption is that if Greeks want to stay in the currency union, they know what they must do: tighten fiscal policy as much as required and push through the agreed economic reforms. Greece, admittedly, is very poorly governed. But this narrative is still misleading, because the extent of fiscal austerity that the Greeks have been required to follow has been self-defeating, pushing the economy into a deep slump and causing a dramatic rise in public debt.
The second problem is that this analysis underestimates the contagion risk posed by a Greek exit. The Greek crisis has already led to a steep rise in the borrowing costs of the weaker euro-zone economies and caused a renewed loss of investor confidence in their banks.
The reasons for this are obvious: Once it becomes clear that euro-zone membership is not forever, the risks of lending to other member states (or their banks) that face economic stagnation and unachievable fiscal targets within the currency will increase still further. Capital flight would accelerate, weakening banks and the sovereigns responsible for backstopping them.
The third problem with the belief that a Greek exit would somehow be a cleansing experience is that it assumes Greece could simply be pushed out and left to its fate as a tragic example of the risks of noncompliance with bailout programs. But this is not what would happen. Aside from accepting huge write-downs on loans , the rest of the euro zone would have to provide Greece with ongoing support in order to shore up its banks and its public finances. The alternative could be social and economic collapse.
With help from the euro zone and the I.M.F., Greece might well recover relatively quickly outside the euro zone, making the option of withdrawal attractive to other countries facing depression and an erosion of policy sovereignty within the currency union.
The best way to limit contagion would be to keep Greece in the euro zone. However, the political obstacles to continued Greek membership are almost certainly insurmountable. It is true that Greece’s predicament owes much to the policies it has been required to pursue by the euro zone, the I.M.F. and European Central Bank.
But the corruption of the Greek political system understandably makes it hard for other countries to make concessions to the Greeks or to feel confident about sharing a common currency with them. The reforms needed to save the euro will require a high degree of solidarity, something which will be difficult with Greece still in the currency union.
The question therefore is how to make a Greek ejection compatible with the survival of the single currency.
The exclusion of Greece would clearly have to be accompanied by the establishment of a much bigger bailout fund in order to increase the size of the so-called firewall around the other vulnerable member states.
But stemming the contagion caused by Greece leaving the euro would need much more than that; it would require three major reforms:
First, an agreement to mutualize — that is, assume joint responsibility for — a proportion of each member-state’s public debt. Second, the introduction of pan-euro-zone bank protection, under which responsibility for back-stopping banks would move from national governments to the euro zone as a whole. Third, an agreement to broaden the E.C.B.’s mandate, opening the way for it to fully undertake the lender-of-last-resort functions required of a central bank.
A Greek exit would increase, not lessen, the challenges facing the single currency. Far from reducing the need for fundamental institutional reforms, a Greek departure would increase the need for them.
If the currency union is to avoid contagion it will need to accompany the loss of its most controversial member with measures that key member states have persistently opposed.
The likelihood of this happening will to a large extent come down to what happens in Germany. Will the German authorities calculate that fundamental reforms are in Germany’s economic and political interests? And, if so, will they be able to persuade a skeptical country that this is the case?
Simon Tilford is chief economist at the Center for European Reform.
