Avoiding a 'Grexit' should be the euro zone's top priority

Euro critics claim that breakup is both inevitable and preferable. But this reasoning underplays the real risks of a sudden shock and ignores the benefits of the common currency.

Last Friday saw one of the sharpest falls in stockmarkets worldwide since the financial meltdown in October 2008. Higher unemployment and lower manufacturing output in the US and Europe have exacerbated fears of a global slump, with the world economy on the brink of a second recession in three years.

By far the greatest threat to the recovery is the growing uncertainty over the euro zone. Contagion has spread to Spain and Italy, where borrowing costs soared to the dangerous threshold of 7 per cent for 10 year sovereign bonds, a level that triggered bailouts for Greece, Ireland and Portugal.

The immediate reason for market panic is the urgent need to recapitalise Spanish banks, which are laden with €186 billion (Dh850 billion) in struggling property loans. Bankia, the country's third largest banking conglomerate, requires about €20 billion in emergency funding to prevent a Lehman-style bankruptcy that could cause another global credit crunch.

If Spain borrows more money on the open markets to prop up its ailing banks (as it plans to do in a risky bond auction on Tuesday) it risks defaulting on its sovereign debt. If the government in Madrid makes even deeper spending cuts to limit higher borrowing, the deepening recession will raise the real value of Spanish debt and could lead to a bailout. Either way, the country urgently needs external help.

The trouble is that the European Central Bank seems reluctant to intervene, and funds from the euro zone rescue mechanism cannot be used for bank recapitalisation. Worse, both Spain and Italy are too-big-to-fail and too-big-to-bail.

Meanwhile, Greece is edging closer to a messy default and a forced exit from the euro - a dangerous precedent that could lead to the unravelling of the entire euro project. As such, Europe confronts a fundamental choice within the next month: either monetary break-up or fiscal union.

Critics of the euro claim that break-up is both inevitable and preferable to a fully-fledged federal state. They claim that the periphery is stuck in a death loop of austerity-induced depression that leads to higher, not lower debt. This, coupled with long-term productivity differentials and trade imbalances, makes the whole euro zone unsustainable.

Countries such as Greece, Italy and Spain - so the argument goes - need to default on their external debt, reintroduce national currencies and devalue in order to generate growth and reduce soaring unemployment, especially amongst the young.

However, this argument underplays the real risks of a sudden break-up and ignores the benefits of the common currency.

Greece's exit, whether voluntary or not, would likely destroy the Greek economy and plunge the rest of the euro zone into meltdown. There is no mechanism for leaving the euro without also leaving the European Union. If Athens reintroduced the drachma, it would have to impose capital controls to stop capital flight. That would violate the free movement of capital, which is one of the four fundamental freedoms of the EU's single market.

The idea of Greek troops patrolling the country's porous borders to stop people from carrying their savings to foreign banks is preposterous.

Indeed, a Greek exit could have most, if not all, of the following consequences: a collapse of the banking and financial system; a slump in national output by as much as 40 to 50 per cent; mass unemployment; and hyperinflation. Even a new drachma that is significantly devalued vis-à-vis the euro won't change all this because the export sector is too small to save what would be left of the country's economy.

Moreover, Greece would isolate itself and create a permanent precedent for the euro zone and the EU as a whole. In the short-term, that could lead to bank runs in Spain and Italy and cause another credit crunch from which the euro would struggle to recover. As Europe is the single largest economic space in the world, a depression there would drag down the fledgling US economic recovery and hit emerging markets hard.

Arguments in favour of a break-up also ignore the substantial benefits of the euro. One advantage is more trade and lower transaction costs within the EU's single market thanks to the absence of exchange rate volatility. Another benefit is the ability of businesses to raise money for investment through greater capital market integration and the influx of foreign savings.

A third advantage is that small, open economies like Greece, Portugal and Ireland are protected against external shocks and speculative attacks on their currencies or banking systems.

For all these reasons, Greece wants to stay in the euro. The next government will try to renegotiate the draconian austerity programme and obtain further debt relief in 2013. On these two points, if little else, most parties and people agree.

Austerity alone isn't working, but the fear of default can prevail over anger about cuts. That is why voters in Ireland ratified the EU fiscal pact by a margin of 60-40 on Friday.

None of this will save the euro or rescue the global economic recovery. But avoiding a sudden "Grexit" will buy Europe time to commit to a fiscal union, including bank recapitalisation.

Athens' best bargaining chip is growing risk aversion and the general desire to limit economic uncertainty. Friday's stockmarket crash foreshadows the sheer sense of panic that a messy Greek exit would unleash across governments and markets alike.

Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille in France