ANALYSIS - Costs of any Greek euro exit may be prohibitive

Sat May 7, 2011 2:42am IST
By Noah Barkin and Paul Taylor

BERLIN (Reuters) - The costs to a country of leaving the euro zone would be so high that many analysts think the bloc will do everything in its power to prevent an exit, even if that requires the richest members to keep bailing out weak states.

German magazine Spiegel reported on Friday that the Greek government had raised the possibility of breaking away from the 12-year-old euro area and reintroducing its own currency in talks with the European Commission and other member states in recent days.

The report was vigorously denied by the Greek finance ministry and officials from other member states. Sources did confirm that a small group of euro zone finance ministers were meeting in Luxembourg on Friday to discuss Greece and other pressing matters.

Leaving the currency union would carry huge economic, social, reputational and strategic costs for Greece or any other country. Greece would have to hive off its bank deposits from the rest of the euro zone banking system as it introduced a new currency, risking a run on its banks and huge disruption for its companies.

Banks across Europe would face losses on their Greek debt.

For the bloc as a whole, it would represent a humiliating setback because the common currency is broadly viewed as the culmination of half a century of European integration.

"To me the euro zone is a one-way street," said Gilles Moec, senior European economist at Deutsche Bank. "A breakup would have catastrophic consequences for the country that left. It would precipitate a run on the banks. I can't see how you do it in an orderly way."

Speculation about a possible euro zone breakup reached fever pitch in November of last year, but predictions that the bloc will fracture have come mainly from Anglo-Saxon sceptics.

Last summer, British economist Christopher Smallwood of consultants Capital Economics produced a 20-page paper entitled "Why the euro zone needs to break up" and U.S. economist Nouriel Roubini, nicknamed Dr. Doom, has said euro members will be forced to abandon the shared currency.

DEBT RESTRUCTURING RISK

Greece has struggled to meet the fiscal targets set out for it as part of its 110 billion euro ($160 billion) bailout from the European Union and International Monetary Fund.

Over the past month, markets have priced in the sort of default risk that was once unthinkable for a euro zone state and expectations have risen that Greece will have to restructure its 327 billion euro debt load while other countries will have to provide more aid.

Political opposition in northern Europe to giving Greece more money and rising anger within the country at the tough austerity measures the government has put in place have created a dangerous new dynamic that has convinced more experts an exit may conceivably happen, although probably not for years.

By reintroducing the drachma, the argument goes, Greece could sharply devalue its currency against the euro and keep official interest rates ultra-low, regain competitiveness, and tackle its debt problem without the political and social upheaval associated with years of austerity-fuelled recession.

"I'm not suggesting that these stories are right," said Jonathan Loynes, chief European economist at Capital Economics. "But we have said that we think it's quite likely that there will be some change to the membership of the euro area over the next four to five years and that one possible form will be the exit of a small economy like Greece.

"I don't think the idea is implausible at all."

But U.S. economist Barry Eichengreen, who authored a 2007 paper arguing that the single currency could not be undone, reaffirmed that belief last year as the Greek crisis deepened.

"Adopting the euro is effectively irreversible," he wrote in an article on the economics website Vox.

"Leaving would require lengthy preparations, which, given the anticipated devaluation, would trigger the mother of all financial crises," said Eichengreen, a professor at the University of California, Berkeley.

LEGAL NIGHTMARE

There is no legal procedure for leaving the euro zone and some economists argue that treaty changes would have to take place before an exit could happen.

"You would have to make it legal in order to leave," said Moec of Deutsche Bank. "You would probably have years of litigation on all the debt held outside the country."

Trade flows would probably be severely disrupted. Business costs would become unpredictable, inhibiting investment. Labour unrest and social strife would likely result as citizens faced mass unemployment, inflation and brutal public spending cuts.

That would far outweigh any potential boost to exports or tourism revenues from a devaluation.

"But what if the bank runs and financial crisis happen anyway?" Nobel prize-winning economist Paul Krugman asked on his blog last November.

An exit that is neither planned nor chosen but imposed by irresistible market forces would dramatically reduce the marginal cost of leaving the euro, Krugman contended.

But that economic logic may underestimate the political will that has driven European monetary union since its inception.

(Additional reporting by Emelia Sithole in London; Writing by Noah Barkin; Editing by Ruth Pitchford, sourced Reuters)