What Happens If Greece Leaves the Euro

The European Union experiment could be coming to an end. As the euro continues to slide, a wide range of interested parties -- from international investors to op-ed pages -- are seriously considering the once unthinkable: Greece might become the first country to drop the euro.

Last week the EU and the European Central Bank unveiled a trillion-dollar bailout plan to stem the "contagion" from Greece's colossal debt burden, but there is not enough money to back up Europe's debts. Greece will almost certainly default and switch to a cheaper currency to avoid a long and painful recession.

Here are two reasons why Greece will have to leave the euro and three reasons why it will still be in a world of hurt (thanks to AEI's Desmond Lachman):

2 Reasons for Greece to Bail
(...really, two sides of the same coin)

1) Wages Must Fall. Wages and prices in Greece will have to fall by nearly 20 percent for the country to regain competitiveness. There are a couple ways to achieve that. One is a deep, lasting, painful recession. How deep, lasting and painful? As Paul Krugman notes, "unemployment has risen from 6 percent before the crisis to 22.3 percent now -- and wages are, indeed, falling. But even in Latvia labor costs have fallen only 5.4 percent from their peak; so it will take years of suffering to restore competitiveness." There is another way. Drop the euro, move to a currency you can control and devalue like crazy.

2) Exports Must Rise. To bring down its deficit, Greece will have to cut spending by nearly 10 percent of GDP, which is an incredible amount of demand to take out of the economy. How do you replace lower domestic demand? With higher foreign demand, also known as exports. A cheaper currency means cheaper olives, which means more people who can afford more olives, which means more demand for olives. A devalued drachma would increase sales of Greek products abroad.

And 3 Reasons Why It Will Hurt

1) No More EU Benefits. As the rules appear to be written, if Greece leaves the euro, it leaves the European Union. So what? Well, Greece receives structural transfers from the European Union because it's a poorer country. That will change if Greece drops the currency. What's more, Greece's closest economic ties are with EU countries. If it leaves the EU, it leaves on unfavorable terms, and could lose trade preferences like low tariffs. (On the other hand, Lachman allows, it's hard to know exactly how Greece would transition out. After all, there weren't supposed to be EU bailouts in the original charter and now we've got a $1 trillion emergency bailout fund.)

2) No More Special Rates. Another huge advantage of the euro is that it allowed Greece to borrow at low interest rates (for a while, at least). Markets convinced themselves that Greece would integrate its fiscal policy with the other countries in the Union, and that the euro was impregnable, which allowed a typically troubled nation like Greece to borrow at near Germany's interest rate levels. Following default and a currency devaluation, Greece won't have that special treatment among international investors.

3) Bank Runs. Anybody who's got a euro deposit that might be translated into drachmas should, and will, think seriously about transferring their money to Germany. After all, imagine that you deposit $100 in Thompson Bank. Then by some dictate, I convert your dollars to dereks, at 80% value. You will not like that! So preemptively, you'll pull your money and put it into Indiviglio Bank or McArdle Bank. That's basically what's already happening in some banks in Greece.