Does the euro need Greece more than Greece needs the euro?

Gavin Hewitt puts it another way in his most recent column, but that's basically the question he's asking:

Eurozone debt crisis: Greece's wild card

When the G20 finance ministers gather in Paris they face a stark fact: that nearly a year and a half since Greece received its first bailout, the crisis remains unresolved. Europe's leaders will be asked yet again what they are going to do with Greece.

...But there is another factor in all this, a wild card: the Greek people. It is just possible that the Greek people will have their say, that they will simply refuse to go along with austerity plans demanded by outsiders, their creditors.

What happens if a people simply says "no"? What happens if, through many small and not-so-small actions, they sabotage the plan?

I think of it like this: Greece and the core eurozone countries (Germany, France, etc.) are in the process of trying to apportion the additional costs of fixing the crisis. Is local austerity ("punishment" is a more accurate term in my opinion) going to be the main mechanism to pay for the solution, or will the crisis mainly be solved through direct assistance from Germany and France? So far the costs of this crisis have been mainly borne by the Greeks through austerity-punishment, but there's a limit to how much of that can be imposed. To better understand who will pay the additional costs of resolving this crisis, it's helpful to think about the incentives each side has to voluntarily shoulder the burden.


Greece

Yes, of course Greece has some awfully compelling reasons to try to avoid a unilateral default on its debt, and to shoulder some of the cost of avoiding that outcome. If at some point Greece is forced into unilateral default, it will face the prospect of losing all further financial assistance from the rest of the EU, a run on domestic banks and complete shutdown of its financial system, an immediate inability for the Greek government to pay all of its bills (even excluding interest payments), and a wave of Greek corporate bankruptcies. As I've argued before, I think that this would very quickly lead to Greece issuing its own domestic currency (which would probably operate in parallel with the euro rather than replacing it). And that would lead to rapid inflation, depreciation, and a drop in Greece's purchasing power. In a nutshell, the outcome for Greece would be very bad. So Greece undeniably has a strong incentive to comply with Germany's demands for continued austerity-punishment.

But keep in mind that once the trauma of unilateral default and the introduction of a new local currency has faded a bit, Greece could be in a very good position to stage a strong economic recovery. Argentina has pointed the way as far as that goes. So while that prospect doesn't mean that unilateral default would be a good outcome for Greece, it does mean that it's a dark cloud with a silver lining, and therefore a slightly less-bad option than it would otherwise be.


The Eurozone

But the outcome for the rest of the eurozone countries could be equally devastating. The main problem they face is that markets are looking to Greece for information about what the core eurozone countries are willing to do to keep the eurozone together. If Greece is allowed to unilaterally default, the markets will have their worst fears confirmed -- that the core countries are willing to allow other eurozone countries default and effectively exit. European financial markets will immediately be devastated by contagion as a massive selloff in Spanish and Italian debt quickly pushes weak eurozone banks to the brink of collapse. The eurozone will face the prospect of having to come up with perhaps in excess of a trillion euro to support the Spanish and Italian government debt markets and to rescue the entire European banking system from collapse.

It is difficult to overstate the seriousness of the crisis that would hit European financial markets in the wake of a unilateral Greek default, I think. This gives France and Germany an enormous incentive to bail out Greece -- for their own pure self interest.

If on the other hand the core eurozone countries actually do come through with sufficient funds to finally resolve the Greece issue, then all of a sudden markets will have important evidence that the core countries are indeed determined to do whatever is necessary to keep the eurozone whole. Put simply: if Germany is willing to pay up to keep Greece in the system, then it's pretty likely that it will also do what is necessary to keep Spain and Italy in the system. Investors' fears are soothed, and contagion largely goes away.


When Greece Hits its Limit

Given this, I would actually argue that the eurozone needs a Greek rescue more than Greece does. At some point soon -- if it hasn't already -- Greece is going to reach its limit regarding the austerity-punishment it is willing to accept. The Greek government will continue to miss deficit reduction goals set by the ECB and Germany, and will be unable to raise additional taxes or cut government spending further without the Greek people triggering the government's complete collapse. And given that this crisis is largely the result of forces beyond Greece's control, I wouldn't really blame them.

When that happens, Germany and France are going to have to think very, very carefully about their response. The immediate reaction of a lot of people at that point will be to throw Greece to the wolves. But if more sober heads prevail, the sort of reasoning I've outlined here suggests that it will be in the eurozone's own interest to swallow its pride and hand over whatever amount of money it takes to keep Greece in the system.