Why Greece Really Matters

As promised yesterday, I want to talk about how the Greek situation could end up disrupting Europe and the European financial system, but in a completely different way than most people expect.

The possibilities for Greece

I see three different directions the Greek situation could go.

Things continue pretty much the way they are now. Additional aid trickles in, but just enough to prevent complete collapse and not enough to allow Greece to recover. This is where we’ve been for the past several years, and it now seems the least likely outcome, as the Greeks, the Germans, and everyone else have completely lost patience with the process and with each other.

A comprehensive settlement, including debt forgiveness, is put in place in exchange for real, thorough Greek governmental and financial reforms. I won’t rule this out—although more from hope than from conviction—as it would represent the best solution for everyone. But with the politics becoming more stressed by the day, it’s not the most probable scenario, in my opinion.

Greece defaults on its debt and leaves the euro. Unfortunately, this outcome looks the most likely. We’ve talked about the possible systemic consequences of a Greek exit before, but consider the effects on the country itself. Greece would have to reintroduce the drachma, renegotiate or repudiate all existing debt, find ways to pay for necessary imports—the list goes on and on. In any event, the short-term consequences would be dramatic and disruptive.

Longer-term, things could get interesting

If Greece leaves the euro, it will either recover or continue to sink. Sinking is self-explanatory, but a recovery is both possible and reasonable. Once Greece defaults, it acquires several significant advantages. Debt payments go away, at least until a settlement is reached. The new currency, the drachma, is much cheaper than the euro, giving Greece a real cost advantage against eurozone countries.

This, in fact, would be a repeat of the strategy Greece and other Mediterranean countries have used, very successfully, over the past couple of centuries: load up with debt, default, and devalue. The problem those countries face under the euro is that they can’t do the second and third steps. By leaving the euro, Greece can default, devalue, and reasonably expect to recover, just as it’s done in the past.

This is exactly how the euro could fail. If Greece exits and then recovers strongly with a cheaper currency and less debt, the other indebted countries will look around and think “Why not us?” In particular, Italy and Spain, which historically have done the default and devalue dance, have struggled to grow under the euro’s discipline. Should Greece leave and prosper, average voters in the other countries are bound to become even more reluctant to continue suffering than they are now.

What’s worse: Greek success or Greek failure?

Most of the concern about Greece’s debt crisis centers on the potential costs of a Greek exit and failure. In my opinion, the real risk of euro failure comes from a successful Greek exit. Either way, there's no reasonable path that brings the euro back as a central currency, and its appeal stands to take a serious hit.