Europe's Impossible Choice: The Greek Exit Paradox

German Chancellor Angela Merkel and French President Nicolas Sarkozy have both said that Greece will not leave the euro, but the "unthinkable" is now being seriously considered at all levels. Just who gets to make that call, and whether sticking or twisting would be the more painful option, is being hotly debated.

Aris Messinis | AFP | Getty Images A man walks outside the Bank of Greece headquarters during a demonstation against government's austerity measures in central Athens.

A Greek exit from the euro would be unprecedented, and some analysts have seen it as an irreversible step towards a breakup of the single currency in its current form. Others say that the country is a "diseased limb" that needs to be excised to protect the remaining countries and save the euro zone.

Saving Greece introduces issues of moral hazard, but letting it fail and fall away seems to run counter to the European vision of mutual support and solidarity.

Letting Greece stay in shows the solidity of the euro zone, and the commitment of the whole to its member states, political analysts say. But it could also tell markets that Brussels is incapable of taking the tough decisions needed to make the union viable economically.

A report, released on Tuesday by Citigroup economist Willem Buiter, said that while Greece leaving the single currency looks more likely than ever, it would have very limited benefits for the country or the euro area as a whole, and that it would have large direct and indirect negative effects on both.

Citi believes that Greek government debt will reach 167 percent of gross domestic product (GDP) by the end of 2011. Slippage in the reform and privatization program as well as worse-than-expected growth figures have blown the country's attempts to rein in its unsustainable debt.

"Structural reforms are going nowhere and the lack of realism in the forecast of the proceeds from privatization is becoming clear," Buiter wrote. "Austerity fatigue in Greece is visible and audible, and so is bailout fatigue in the core euro area member states."

'Reform Fatigue'

Speaking on Thursday evening, Christine Lagarde, the new head of the IMF, said that Greece was suffering from "reform fatigue".

Practically, what does that mean?

First, Greece will probably default at some stage. The timing and nature of that default depend on a number of factors, not least the appetite among the more developed member states to keep throwing money at the problem while other vulnerable economies make good their own structural reforms.

The ability of the Greek government to continue with its cutbacks despite opposition from its own population is also critical. Should the "Troika" of the International Monetary Fund (IMF), European Union and European Central Bank (ECB) determine that the country is "willfully non-compliant" with its conditional structural reforms, financing could be withheld and the country would almost inevitably default.

The ECB would no longer accept Greek government debt as collateral when lending to the country's banks, and the emergency liquidity assistance (ELA) offered by the ECB would not be forthcoming. This, Buiter said, could push Greece to leave the euro of its own volition.

"Faced with the disappearance (as far as Greek banks and sovereign are concerned) of the euro area lender of last resort, Greece could blunder into exiting from the euro area. It is the denial of access for banks to ECB/Eurosystem funding and to the ELA facility that would be the defining moment for Greece in our view," Buiter wrote.

In this scenario, Greece would be unlikely to pay back most of its international creditors, except for the IMF, Buiter said.

So why not leave? After all, competitive devaluation of currencies against the deutschmark was key to the performance of Southern European economies pre-euro. As Buiter explained, a reincarnated drachma would instantly lose value – he estimates as much as 40 percent. As soon as a euro exit appeared inevitable, there would be a run on the banks.

"The Greek banking system would be destroyed even before Greece had left the euro area," Buiter said.

Institutions holding drachma instruments, and those still denominated in euros would see huge imbalances develop in their portfolio. Corporates exposed in this way, and any remaining banks, would have a high chance of following the sovereign and defaulting.

The competitive benefits of devaluation, Buiter noted, would be short-lived without the same structural reforms to the economy and labor market that the Troika has prescribed. Leaving the euro, he concluded, would lead to a financial collapse and a deeper recession than it is currently suffering from.