How the eurozone handles Greece will determine whether or not the single currency survives - and hence the future of the European Union as a whole. If a Greek exit from the eurozone 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 eurozone if it freed up the political space needed for the German authorities to embrace such reforms.
Some eurozone policy-makers believe that a Greek ousting from the single currency would be a cathartic experience. A Greek eviction would demonstrate to other struggling eurozone economies the risks of backsliding on their fiscal targets or the terms of their bailout programmes. The risk of contagion would be limited, as governments would have no choice but to accept and adapt to the situation, which would in turn reassure investors about the sustainability of their public finances. According to this analysis, the ejection of Greece would obviate the need for big institutional reforms of the currency union such as debt mutualisation or pan-eurozone bank-protection.
The clean-break illusion
There are three problems with this line of reasoning. First, it assumes that Greece and other hard-hit members of the eurozone could meet their fiscal targets if only they tried harder to do so. This is an example of the flawed reasoning that has driven the eurozone's policy response to date and which 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 is admittedly a very poorly-governed country. 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 with this analysis is that it underestimates the contagion risk posed by a Greek exit. The political crisis in Greece and the mounting risk of it leaving the euro has already led to a steep rise in the borrowing costs of the weaker eurozone economies and caused a renewed loss of investor confidence in their banks.
The reasons for this are obvious: a Greek departure would expose the supposed irreversibility of eurozone membership as a myth. Once it becomes clear that membership is not forever, the risks of lending to other struggling member-states (or their banks) that face economic stagnation and unachievable fiscal targets within the currency will increase still further. Capital flight from the struggling member-states 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 non-compliance with bail-out programmes. But this is not what would happen. Aside from accepting huge write-downs on money they have lent to Greece, the rest of the eurozone 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, and the possible creation of a failed state within the EU.
Indeed, a Greek departure would create a precedent but it could well be an awkward one. With help from the eurozone and International Monetary Fund (IMF), Greece might well recover relatively quickly outside the eurozone, making the option of withdrawal attractive to other countries facing depressions and an erosion of policy sovereignty within the currency union.
The best way of limiting contagion would be to keep Greece in the eurozone. 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 troika of the eurozone, the IMF and the European central bank (ECB). But the clientelism and corruption of the Greek political system understandably make 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 between participating economies, something which will be difficult with Greece still in the currency union.
The reform imperative
The question is therefore how to make a Greek ejection from the eurozone 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:
* An agreement to mutualise (that is, assume joint responsibility for) a proportion of each member-state's public debt
* The introduction of pan-eurozone bank-protection, under which responsibility for backstopping banks would move from national governments to the eurozone as a whole
* An agreement to broaden the ECB's mandate, so as to open the way for it fully to undertake the lender-of-last-resort functions required of a central bank.
A Greek exit from the eurozone would increase, not lessen, the challenges facing the single currency. Far from reducing the need for fundamental institutional reforms of the eurozone, a Greek departure would further 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 sceptical country that this is the case?