Not Solving the Greek Debt Crisis Might Just Solve the Greek Debt Crisis

Everybody assumed that when Greece defaulted, Europe would fall apart. This weekend, Greece defaulted. And Europe's still around. What if extend-and-pretend actually works?


ReutersGreece and the euro zone are the Sid and Nancy of currency unions. We know these crazy kids are going to break up eventually -- so why not go ahead and get it over with already? The answer is that neither side is prepared for their inevitable divorce. The Germans have roughly a trillion reasons to keep Greece around for now. And the Greeks, for their part, still want to stay in the euro zone. The prospect of bringing back the drachma simply terrifies many of them. It shouldn't. Greece's recent managed default shows that leaving the euro, though ignominious, wouldn't need to be the end of the world.

A Greek exit from the euro zone seems a fait accompli. It has little to do with Greece's genuinely profligate government spending, and everything to do with Greece's labor costs. Greece's wages are simply too high to compete with the rest of Europe, particularly Germany. There's usually a simple remedy for this: devalue the currency. But euro membership precludes Greece from doing that. Instead, Greece is being forced to go through an "internal devaluation" -- econospeak for cutting wages. The resulting sky-high unemployment is socially unsustainable. And, as Meg Greene points out, it's unlikely to improve much within the next decade.  

For Greece, the euro is not worth a perma-slump. Unfortunately, though, resurrecting the drachma might not make things any better -- for now, at least. And Greece's primary deficit has everything to do with why.

Even if Greece defaulted on all of its debt and left the euro zone, it would still be running a large deficit. The country would be stuck between two equally nauseous choices: hyperinflation and hyperausterity. In other words: It could drown the problem with money or starve the problem with cuts.

Both are nightmarish. So long as it's part of the euro zone, Greece can close its deficit with a mix of austerity and money from Germany. If it leaves the euro, Greece is on its own, and it would have to rely on much deeper cuts -- or tax hikes -- to close its deficit. Such austerity on steroids is a painful option. It would create a rather massive temptation for a country as chronically ill-managed as Greece to print its way out of trouble. But if Greece simply prints drachmas to pay its bills, inflation would take off -- perhaps even to Weimar levels.

None of this means that Greece shouldn't leave the euro zone. It means that Greece shouldn't leave the euro zone too soon. Consider the case of Greece's recent default. Markets shrugged off the 74 percent writedown on Greece's privately held debt, because there had been plenty of time to prepare for it. Even the payouts on the much-hyped credit default swaps on Greek debt turned out to be a relative non-event.

In other words, the can-kicking worked! If Greece had defaulted like this two years ago, when its debt problems first roiled markets, the result likely would have been panic. Today, it elicited more headlines than actual worries.

The lesson is clear: Greece and Germany should keep kicking that can! As soon as Greece's budget reaches a primary surplus, they should announce capital controls (to forestall the unavoidable bank runs), negotiate a writedown of the remainder of their debt -- and bid adieu to the euro. The transition to the drachma will still be hellacious, but doable.

Greece and Germany are careening towards an ugly breakup. But it doesn't have to be that way. They can still be friends -- as long as they commit to making their dysfunctional relationship work for just a bit longer.