What Happens If Greece Exits the Eurozone?

People hold a rally in front of the Greek parliament in Athens as "No" vote ahead in Greek referendum on July 5, 2015. Crowds are beginning to gather in the squares of Athens waiting for the official result in Athens, Greece. Photo: SAKIS MITROLIDIS

Following Greek voters’ overwhelming rejection on Sunday of a bailout deal offered by its creditors, the long-feared possibility that Greece will exit the eurozone seems more likely than ever. With Greek banks closed and the nation facing several high-stakes deadlines over the coming weeks, European leaders are now scrambling to reach an agreement that will allow Greece to continue using the euro. The so-called “Grexit” is often referred to as a doomsday scenario, but there’s actually little consensus on what it would entail. And while some experts say abandoning the euro would be catastrophic for Greece and cause serious problems for the entire European Union, some argue that it’s actually the smartest way to solve the Greek debt crisis once and for all.

Most agree that in the short-term, going off the euro would lead to more hardships for the Greek people. Dr. Holger Schmieding, chief economist at Berenberg Bank in London and former adviser to the International Monetary Fund, told Australia’s ABC News that transitioning back to the drachma (or a currency with a new name) would likely entail “months of confusion, hectic negotiations,” as there’s no legal road map for how the exit would work. He continued:

Then the currency that comes into existence under these circumstances — while Greece is in deep recession, while capital is flowing out of the country, while the government has lost a lot of economic credibility — a currency that comes into existence under these circumstances would likely be extremely weak, have high inflation, and that would mean that prices for oil, food would be very expensive.

Last week, Standard & Poor’s said the Grexit would cause “severe” consequences for Greece’s economy. The credit ratings agency predicted that soon after exiting the eurozone, the country’s real GDP would drop 25 percent, and in four years it would still be 20 percent lower than it would have been. It also said unemployment, which is already above 25 percent, would increase past 29 percent and only come down gradually. Others predict Greeks would see a 40 percent drop in their purchasing power, Greek businesses that borrowed in foreign markets could go bankrupt, and imports may need to be rationed. Plus, such tremendous economic problems could spark political upheaval.

However, many believe that in the long-term, reintroducing the drachma will allow Greece to reinvigorate its economy. Economist Joseph Gagnon of the Peterson Institute for International Economics in Washington wrote this week that while the Greek government is facing massive challenges, if it plays its cards right, “the Greek economy could begin to grow within six months and accelerate strongly over the next two or three years.”

Writing in Forbes, University of Georgia economics professor Jeffrey Dorfman argued that Greece and the rest of the E.U. could negotiate a “Grexit” that’s a win for both sides:

The idea here is simple. Greece leaves the eurozone (a Grexit) and returns to the drachma. Greece declares one drachma is worth one euro. They then print about $300 billion worth of drachmas (it would really just be electronic money for the most part, so the mechanics are simple). They use about $260 billion to pay off the ECB and IMF, redeeming all their bailout funds and technically avoiding a default as long as the ECB and IMF play along. Greece then uses the remaining $40 billion or so to recapitalize its banks so they can reopen and depositors can withdraw their funds freely. Greece’s remaining debt load is manageable with their current fiscal policy, so no major tax increases or austerity should be needed.

Dorfman added that to avoid inflation, the ECB and IMF just need to leave the drachmas in their vaults. “Then the money supply is only increased slightly and there will likely be only a moderate devaluation of the drachma, leading to ‘acceptable’ inflation considering the alternatives.” Dennis J. Snower, president of the Kiel Institute for the World Economy, described a different scenario but agreed that returning to the drachma could mean a “new beginning” for every nation that uses the euro:

Under this program, creditor countries would write off Greece’s debts, on the condition that the country left the eurozone voluntarily. This would give Greece the opportunity to start afresh from outside the monetary union: it could restructure its economy without outside interference, and could be ready to re-enter the eurozone at a later point under new conditions – this time without false statistical pretenses or unrealistic expectations.

Such an option would allow the Greek government to make a new start in stimulating competition, fighting corruption, and otherwise building a basis for long-term growth. This would not be easy, but it would no longer be a process that Greece finds humiliating and creditor countries find exasperating.

As for the rest of the eurozone, “Its member states would accept that monetary union is impossible without fiscal and structural coordination.” Michael G. Jacobides, a professor at the London Business School, counters in Harvard Business Review that Greece needs to cling to the E.U. to prevent further catastrophe:

The bottom line is that away from the EU, Greece will slip ever further into an economic abyss, characterized by rising income inequality and poverty. This is where most economists, who consider the upsides (for Greece) of a Grexit, have it wrong. The country’s failings are structural, not just fiscal. Default and Grexit will only aggravate those structural failings, not only immediately, but also in the medium-term. And having a failed state in such a pivotal geographic location as Greece’s poses significant geopolitical risks.

At one point there were fears that a Grexit would send shockwaves through the world’s financial markets, but over the past few years the E.U. has taken steps to lower the contagion risk. Ironically, some are arguing that the E.U. should be most worried about Greece succeeding on the drachma. On Monday a New York Times editorial said “European leaders have made the crisis worse by their mismanagement,” and now it’s their responsibility to find a way to keep eurozone together — if not for Greece, for their own sake:

A Greek exit would also do untold damage to the credibility of the euro and the European project by making clear that any country’s membership in the eurozone could be revoked. That might not be an immediate concern for other economically weaker countries like Italy, Portugal and Spain, given that yields on their government bonds increased only modestly after the Greek vote. But the specter of more exits from the eurozone would undoubtedly make it hard for European leaders to respond to future crises.