If Greece Leaves, We All Lose

Greece’s Prime Minister Alexis Tsipras is the most powerful man in his country right now. He won Sunday’s referendum by a landslide 61% and in the process gained support from most of the other political parties. Yet he arrived empty-handed at Tuesday’s meeting with creditors, and has since only made vague commitments in his request for further loans. Without a credible reform plan by Friday morning, Mr. Tsipras’s country will likely exit the eurozone.

The potential losses from a Greek exit would be dramatic for the country and its people. A new drachma would be worth about half the value of the euro, according to an average of past devaluations around the world since the 1980s. The depreciation would mean an immediate fall in living standards for the local population. It may also constrain basic imports, like food or medicines, as Greece’s trading partners try to avoid currency losses.

A cheaper currency might boost exports and tourism, but at the moment those industries only make up 32% and 18% of the economy, respectively—not enough to help Greece withstand a recession. On average, leaving a currency peg/union produces a 4.4% contraction in gross domestic product during the first year after an exit, with unemployment and inflation also rising substantially. It’s an unsustainable price to pay for a country that has already seen its economy shrink by about 25% since the crisis.

Creditors would be hurt, too. My analysis at RBS shows the minimum direct cost of leaving the euro would be €227 billion ($250.35 billion), or 2.3% of eurozone GDP, including public and private debt as well as European Central Bank loans to Greek banks.

This excludes the collateral costs. The euro would no longer be considered irreversible: From being a currency union, it would become a peg from which countries could choose to detach.

Geopolitical risk could rise too: Greece hosts seven NATO bases and its air force owns more than 150 F-16 fighters. NATO membership is separate from the eurozone and the European Union, but there is concern that in a severe economic crisis Greece could turn to Vladimir Putin for assistance and strengthen its relationship with Russia.

A restructuring program for Greek debt would be cheaper.

A combination of long-term debt extensions and a haircut may cost around €50 billion to €60 billion, as shown by the International Monetary Fund’s latest report on Greece. Even in a hypothetical one-off haircut, a reduction to a 100% debt-to-GDP ratio would cost around €130 billion (1.3% of eurozone GDP)—less than the full cost of a Greek exit.

The main downside of debt restructuring, according to creditors, is moral hazard: the risk that other countries may ask for the same treatment. These countries include Ireland, which suffered a similar crisis and underwent painful reforms, and Spain, which doesn’t need a debt reduction but is seeing the rise of the Podemos party, whose views are very close to Mr. Tsipras’s hard-left Syriza government. But debt reductions can be structured with long-term conditionality on reforms, not as a free lunch.

Europe’s approach to the crisis has so far been one of denial. At its root, the financial crisis was generated not by subprime mortgages or by banks. Those were the sparks, but the powder keg was a debt overhang accumulated over decades. This overhang includes not only public debt, like in Greece (175% GDP) or Italy (133% GDP), but private debt too—like for households in Holland (112% GDP) or, outside of the eurozone, in Denmark (144%) and the U.K. (93%).

The policy answer to manage excess debt up to now has been to lower interest rates and kick the can down the road. But the overhangs have not fallen, with Europe lacking ways to use capital markets to help restructure its debt. As a result, total debt stands, on average, at more than 400% of GDP in the eurozone. Meanwhile, central banks have reached the end of the line with low interest rates and easy-money policies.

It’s time to face the root problem: Where debt isn’t sustainable, creditors must consider a renegotiation. And just as with private companies, debt renegotiation may mean a second chance for the firm to prosper and for creditors to recover their capital.

The numbers speak clearly: If Greece leaves the euro, we are all losers. This weekend, both sides will have one last opportunity to act as Europeans and not just as nationals of their own countries—to balance reason and common interest with the preferences of their own electorate. The Greek government should commit to deep reforms, and not just focus on short-term tax increases. Creditors can manage moral hazard and should stop using it as a reason to ignore the problem.

The next hours will show whether Mr. Tsipras really does have a plan, or if he has pushed his country and his people to the brink with only a promise.

This article was originally published by The Wall Street Journal on July 9, 2015.

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