Exit Would Be Mess for Athens

The extraordinary events of the past week in Europe have included the shattering of a taboo that could have profound consequences for the Continent: the public discussion by European leaders that Greece could exit the common currency.
The chances of Greece leaving the euro may have fallen on Thursday as the likelihood of a referendum receded. But the open airing of that possibility has broken the single most important rule governing the issue: If you're going to do it, don't advertise it beforehand.
Sending a message that exit is possible risks creating a crisis of confidence that eventually forces a government's hand, with what economists say are potentially disastrous consequences.
"The prospect of Greece exiting the euro area is seldom viewed with the proper degree of fear and trepidation," argues Willem Buiter, chief economist at Citigroup. He says the bottom line of an exit for Greece is financial collapse and an even deeper recession—or even a depression—with significant collateral damage to the rest of the euro zone.
One major issue, as Barry Eichengreen of the University of California, Berkeley, wrote in a 2007 paper, is that if a country signals it is preparing a currency change, it will likely lead to a sharp depreciation as people "rush out of domestic banks and financial assets, threatening a banking and financial-market collapse."
The status of deposits in Greek banks is thus a key indicator of how Greeks view the prospect of a euro-zone exit. Greek banks have already seen a slow, but significant slide in deposits. Figures from the Bank of Greece show household deposits in banks have dropped by a fifth from €196.9 billion ($272 billion) at the end of 2009 to €157.1 billion in August, the last month for which data are available.
If it should happen, leaving the euro would probably be disorganized affair, quite unlike the formal switch from the drachma into the euro in 2002.
Its speed would render moot legal arguments about the absence of a provision in European treaties providing for an exit from the common currency. And since an exit would also likely be associated with capital controls and other moves, probably illegal under European law, it could also be accompanied by a withdrawal from the EU, possibly temporarily.
Historians can cite examples of currency union breakups, including that of the U.S. at the onset of Civil War in 1861. Economists led by Stephane Deo at UBS Investment Research say the best parallel may be the break-up of the Austro-Hungarian Monetary Union in 1919.
The main method of separation was over-stamping existing banknotes, but various parts of the empire also imposed forced loans to governments, capital controls and travel curbs to prevent people carrying suitcases of cash from perceived weak-currency jurisdictions to strong-currency ones.
This model, in theory, could be used in the euro area. With capital controls and curbing of the movement of people across borders, the "physical euro could be stamped and converted into national currency. Bank accounts could first be frozen and then converted at an arbitrary exchange rate," the UBS researchers wrote in a September research report.
They urge caution, however: "Any anticipation of stamping notes would lead to a run on banks in [perceived] weaker currencies—or people hoarding unstamped notes in the hope of converting them in another geographic territory."
Mr. Eichengreen pointed out that past breakups of currency unions were practically easier. Governments "could seal their borders to provide time to stamp old currencies or swap old currencies for new ones," he said. "Firms did not have computerized financial accounts and inventory-management systems. Europe today is a more complicated place."
One key complication of exiting the euro is debt. Switching currencies would require changes in domestic laws to allow wages and incomes to be paid in the new currency. Domestic debt contracts—including mortgages and credit-card bills—would also have to be redenominated so as to prevent the instant bankruptcy of most households, which would see their debts unchanged but their incomes shrunk because they are denominated in new, less valuable drachmas.
Private borrowers—including banks—with debts outside Greece would not be able to re-denominate them in the new national currency and many would go bankrupt or default. Litigation would abound.
The government would also face an intensified debt crisis. Unable to borrow from financial markets, and probably from its erstwhile euro-zone partners, it would be forced to cut its budget deficit to zero. To do this, it would likely have to suspend interest payments to creditors.
Its debt burden—the weight of government debt as a proportion of economic output—would soar. The economy would shrink at a stroke as the new national currency depreciated against the euro, but most of its government bonds would still be euro-denominated.
In the case of Greece, most government bonds are issued under Greek law, and the bonds could be redenominated in new drachma. The debt restructuring euro-zone leaders agreed to last week would cut its private debt in half—but changes the jurisdiction governing the bonds to English law, making redenomination impossible. (It's one likely reason why bank creditors have insisted on the switch of jurisdictions from Greek to English law.) But its loans from euro-zone governments would still be in euro.
If that weren't enough, many economists argue also that the economic benefits of a sharp currency depreciation could be limited. Labor and other costs would fall but an improvement in Greek competitiveness "would be short-lived in the absence of further structural reform of labor markets, product markets and the public sector," Mr. Buiter says. In other words, the benefits would quickly be dissipated by wage inflation.

Leaving the Euro? A Few Things a Government Would Have to Do

• Prepare for a run on banks through bank holidays, limits to deposit withdrawals.
• Prepare for capital flight by introducing temporary capital controls, travel curbs.
• Change the law to re-denominate wages, incomes in new national currency.
• Re-denominate mortgages and other debts in new currency.
• Prepare plan to recapitalize banks.
• Plan to balance budget because government would lose ability to borrow.
• Set fiscal and monetary framework to rebuild policy credibility.
• Prepare new notes and coins for distribution.
• Reprogram computers, change vending and payment machines.

   

Write to Stephen Fidler at stephen.fidler@wsj.com