Europe Has One Trillion Reasons to Keep Greece in the Euro Zone

Losing a billion euros isn't cool. You know what's cool? Losing a trillion euros. And that is precisely what could happen if Greece disorderly defaults and exits the Eurozone, according to the Institute of International Finance (IIF).

What, you thought Greece was "solved"? Ha!

Here's how the IIF breaks down the costs of a disorderly default: $498 billion to stabilize Portugal and Ireland, $459 billion to do the same for Spain and Italy, a $232 billion capital hit to the ECB, $209 billion to recapitalize European banks, and $96 billion in losses for Greek bondholders. The below chart breaks down how these figures fit into the overall picture.

Clearly, the bulk of the costs would come from containing financial contagion in the rest of Europe's periphery. If Greece unexpectedly withdraws from the euro, investors will justifiably wonder if Portugal and Ireland or Spain and Italy are next, and likely dump those bonds. Overwhelming financial force -- i.e., gobs and gobs of money -- would be necessary to end the panic. The IIF price tag for such overwhelming financial force is even larger than TARP.

But as long as the Europeans can avoid a disorderly default, there doesn't seem too much to fear. The system should be able to handle an expected default. After all, private investors are most of the way there after accepting a 74 percent haircut in the latest debt restructuring.

And this explains why the Greek tragedy has turned into a never-ending farce. In game theory terms, the dominant strategy for the Greeks is to stay in the euro zone, but threaten a disorderly default every now and then. Because the costs of an unexpected default are prohibitively high for Europe, but those of an orderly default are not, the Europeans should keep writing down Greece's debts. But this can-kicking will only go so far. Both sides are trying to finesse the current situation to their maximum advantage until they can plausibly divorce. For the Europeans, this means finally creating a firewall-bazooka around the rest of Europe's periphery to prevent contagion. For the Greeks, it means getting their primary budget -- that's all government spending minus interest payments -- into surplus, so they aren't forced to adopt even more austere austerity if they leave the euro zone.

Until then, the Greek crisis will continue to periodically flare up. So sit back and hope that this game of chicken continues to end in a draw.