Euro Crisis: Why a Greek Exit Could Be Much Worse than Expected

by Michael Sivy

Time
May 22, 2012

At the G-8 meeting at Camp David last weekend, lip service was paid to keeping Greece in the euro zone. But economists who are watching the continuing financial crisis in Europe are increasingly coming to two conclusions: Greece is likely to abandon the common euro currency now used by 17 European countries. And when it does, perhaps within a matter of months, there will be a damaging domino effect throughout much of Europe. Not all domino effects are created equal, however. And there are two possible consequences if Greece leaves the euro zone that few observers seem to have considered.

The scenario everyone recognizes is based on Greece’s reviving its traditional currency, the drachma. In this case, salaries and prices within Greece would be converted from euros to drachmas, and the drachma would be allowed to depreciate to make the Greek economy more competitive. The problem comes with debts that are denominated in euros, especially if the lenders are outside of Greece. These lenders would naturally resist being repaid with less valuable drachmas. However, if Greek borrowers have to repay the loans with euros, the debt would become more expensive for them to pay off after the drachma is devalued.

The most likely domino effect, therefore — and the one most widely expected — is that debts to non-Greek creditors would be compromised after Greece switches to the drachma. There would be lawsuits over which currency to use, or borrowers would default on the loans, or lenders would be forced to accept reductions in the amount of the loans that have to be repaid, in order to avoid outright defaults. Whichever outcome occurs, the lenders lose money. Just as in the U.S. mortgage-lending crisis, once some banks lose enough money to become troubled, the contamination spreads to other banks, because they all lend to one another.

That’s not a pleasant prospect, but at least it’s fairly clear how to manage it. Greece leaves the euro zone, and its economy suffers for a couple of years but then stabilizes. With Greece gone, the rest of the euro zone could be propped up more easily. Many major banks take big losses on Greek debt. Some fail, some are taken over by stronger banks. Governments have to bail out the biggest losers. And the banking system is made sound again, although at considerable expense to taxpayers in many countries.

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