Why Greece Can't Leave the Euro

All you hear about in the financial media today is the risk of a Greek exit of the European Monetary Union, or a Grexit as it has been coined, and they all seem to be taking it as more of a when and less of an if. However, is this really the correct way for investors to be considering Greece, since all we have heard all along from Germany is that they do not plan on any nation leaving the European Monetary Union (note, if I use the term euro from now on, I am referring to EMU, not the EU)? As a good business student, let us embark on a classic exercise, a cost-benefit analysis, and what the real costs of a Greek exit vs. a sustained depression in the euro would be.

The real question comes down to this: at what point do the bailout costs, which are expected to be paid back at some point (that is a much bigger, seemingly unanswerable question, but let's just assume that at some point, Greece will be able to pay back the funds), pass the costs of the exit, so that Germany becomes reluctant to help any more? Germany's rising commitment to its weaker brethren is well known, but now, including contingent claims, Germany's crisis-related claims against the rest of Europe are quickly approaching 25% of GDP.

Germany has so far pledged 22 billion euros as part of the first bailout package for Greece. Germany is also liable for 211 billion euros of maximum guarantees for the EFSF and another 190 billion euros for the ESM. Also, Germany is liable for 12 billion euros of the EU budget, most of which has gone to crisis-fighting measures. These are the rather easy to point out costs, however there are a few more less direct costs to Germany.

Even though the ECB's SMP program and Target II balances are monetary in nature, should a Greek exit occur, these two programs would hurt Germany. In terms of the SMP, Germany is responsible for 27.06% of the ECB's capital, so it could lose up to 57 billion euros out of the SMP program. Germany is also responsible for about 179 billion euros of Target II liabilities, but both of these numbers would probably only go up in the case of a Greek exit. Thus, the total costs so far (that could be lost forever in a Greek exit) amount to about 671 billion euros, or about 20.5% of GDP.

However, there are also opportunity costs to letting Greece leave, mainly the costs of inaction and the benefits of Euro area membership. Recently, KfW, a German bank, estimated that Germany gains about 1-1.25% of GDP per year due to a weaker exchange rate and lower interest rates. Also, it is hard to quantify what Germany would look like outside the euro, as exports would probably collapse as a new currency appreciates massively, meaning that as of now, it may even be too hard to calculate the total costs to Germany. For reference, GDP contracted a combined 6% in the two quarters after Lehman failed, and there is less room now for crisis-fighting measures and (most likely) necessary bank bailouts.

Another cost to Germany would be the higher reflation needs of the core. As Credit Suisse points out, since the introduction of the euro, inflation in peripheral nations generally exceeded the 2% ECB target and the core lagged. They argue that the opposite needs to happen for the euro to survive: Germany needs to accept between 2.7-3.2% inflation for 5-8 years and Spain needs to accept between -.2% and 0% inflation for the same period. This way, the core can reflate competitiveness back into the continent.

The question becomes: is Germany willing to risk the costs at the expense of inflation, or is inflation still out of the question? The costs are high, the intangibles higher, and the added costs from letting Greece leave are so high it is hard to count. There really isn't a benefit, except that the further costs would be capped at some much higher level. Germany will probably be reluctant to lose upwards of 1 trillion euros, plus have to deal with higher interest rates, a collapse in exports, and capital flight into the country that would further weaken the periphery and further increase the costs (via Target II) to Germany. All in all, can't we all just accept a little bit of inflation and be done with this?