A Greek exit would be a big deal for Europe

Judging by the pace at which Greece’s politics is unraveling, European policymakers could soon be faced with a fundamental policy choice. Do they again make Herculean efforts to keep Greece within the euro? Or do they allow Greece to be cut loose from the euro? How European policymakers decide to answer this basic question will be critical not only for Greece’s economic future but also for that of the eurozone as a whole.

Voices are now being raised in Europe that Greece’s situation today is very different from what it was some two years ago at the height of the euro crisis, when policymakers feared contagion from a Greek exit. Following a massive debt restructuring in which Greece’s privately owned sovereign debt was written down by 75 percent in 2012, Greece no longer has a particularly high level of privately owned sovereign debt. While, to be sure, Greece does have an extraordinarily high public debt to gross domestic product ratio, the overwhelming majority of that debt is owed to the International Monetary Fund (IMF), the European Union and the European Central Bank (ECB). As such, being a small economy without strong linkages to the European financial system, it is argued that European policymakers can now afford to let Greece be cut loose without the fear of precipitating a European banking crisis.

{mosads}It is also argued that letting Greece go now might be beneficial for the eurozone as a whole in that it might send a salutary message to the political class in the rest of the European periphery. On seeing Greece’s economic and financial chaos, which will almost surely follow its euro exit as its citizens run on its banks, it is thought that the political class in France, Italy, Portugal and Spain will see the folly of not playing by the eurozone’s rules of budget austerity and structural economic reform.

Tempting as these arguments might be, one must hope that European policymakers weigh the very real risks to the eurozone that might result from a hasty Greek exit. Among the more important of those risks is that the resulting run on the Greek banks and further collapse of the Greek economy, which would almost certainly follow a Greek exit, might send a very graphic message to depositors in the rest of the eurozone’s periphery as to what can happen to their deposits. No longer will Eurozone depositors feel secure that their deposits were fully backstopped by the ECB. This might produce real contagion from Greece to countries like Italy, Portugal and Spain, as depositors in those countries rush to withdraw their bank deposits while the going is still good and before their already shaky economies weaken any further.

Another real risk is that a Greek exit might fan the political forces in the eurozone’s core countries opposed to bailing out countries in the European periphery. A financial and economic collapse in Greece will almost certainly cause Greece to default on its very large official debt from the ECB, the IMF and the European Union. As a result, no longer will European policymakers be able to maintain the fiction with their taxpayers that there was little risk in lending money to the European periphery. This might make future European official bailouts more difficult. More importantly, it might make it very difficult for the ECB to activate its Outright Monetary Transaction mechanism, which is already facing strong political opposition, especially in Germany, and which is the central plank of Mario Draghi’s pledge to do “whatever it takes” to save the euro.

Yet another risk that European policymakers might want to consider is that a Greek exit could complicate the ECB’s task of undertaking quantitative easing now to address Europe’s incipient deflation problem. If the ECB is forced to recognize large losses on its past Greek lending, one must expect the resistance of those ECB board members already opposed to ECB quantitative easing to grow. In particular, those members must be expected to strongly resist any notion that the ECB might buy the sovereign bonds of those countries with poor debt dynamic that could result in the ECB incurring further loan losses on its balance sheet.

In September 2008, when U.S. policymakers were faced with the decision as to what to do about Lehman Brothers’ acute financial difficulties, they grossly miscalculated the likely fallout from letting Lehman go bankrupt. That decision had devastating consequences for both the U.S. and global economies. One has to hope that European policymakers have learned the lessons from that sad episode and that they weigh very carefully the pros and cons of letting Greece go before they come to any decision that they might later come to regret.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.