Europe Economy

Father of Grexit: 'Disaster' for euro zone if Greece leaves

We can't handle damage to the European integration: Citi's Buiter

The economist credited with coining the term "Grexit" said Thursday it would be a disaster if Greece leaves the euro zone.

The real risk is not the short-term financial market impact of a Greek default, said Willem Buiter, Citigroup's chief economist. The European Central Bank could manage those events with existing tools, including the activation of a "hyperactive" level of quantitative easing and purchases of sovereign bank debt on the primary market through the European Stability Mechanism.

"You can handle the financial crisis. You cannot handle, I think, the damage to the European integration process," he told CNBC's "Squawk on the Street." "It would be the first time since 1951 that a treaty-based integration process would have been reversed. It would be a disaster."

Greece's international creditors put a final cash-for-reform proposal to euro zone finance ministers on Thursday in a showdown with Athens after lengthy negotiations failed to yield a plan to avert an imminent default.

Defiant Greek ministers said they would stick to their own proposals, based largely on increases in tax and social contributions, which the country's lenders say would not raise enough revenue to plug a gaping budget hole.

Read More Eurogroup meeting ends, Greece deal still far off

Greek Prime Minister Alexis Tsipras leaves the European Commission headquarters after a meeting with the European Commission, the International Monetary Fund (IMF), the European Central Bank (ECB) and the bloc's rescue fund in Brussels, June 25, 2015.
Yves Herman | Reuters

The deadline for Greece to pay 1.6 billion euros ($1.8 billion) to the International Monetary Fund is Tuesday.

Should Greek leaders and creditors fail to reach an agreement, Buiter said capital and deposit controls will likely be enforced and Greece will enter default on its International Monetary Fund commitments. This would be a "huge negative" not just for Greece but for other heavily indebted peripheral economies, he said.

"The possibility of sovereign default would be back in the forefront of people's minds, and they would be asking, 'Who's next?'" he said.

However, he stressed that a Grexit would not be an event, but a process that could take months or years—one that could be reversed by a new government or coalition.

The specter of elections is indeed looming over Greece. Earlier this month, the ruling Syriza party's parliamentary spokesman said Greece's leftist-led government would hold early elections if its international lenders force it to accept a cash-for-reforms deal that violates its "red lines" or risk bankruptcy.

Locked out of bond markets and with bailout aid frozen since last summer, Athens is quickly running out of cash.

Money drained out of Greek banks following a breakdown in talks last week.The ECB has authorized increased emergency lending to Greece throughout the week, extending a lifeline to its banks.

Read MoreWhy investors should care about Greece: Expert

In the event Greece imposes capital controls Monday, the impact on stock and bond markets outside Europe's peripheral economies will be limited, he said. Central banks could potentially flood the market with liquidity in response, creating a buying opportunity in these markets, but certainly not in peripheral euro zone government debt.

"The risk will be mitigated, but it won't be eliminated," he said. "The flooding of the market with further liquidity which is likely to happen especially in the euro area would undoubtedly get into the other liquid asset markets, including bunds, including equities generally, and those might well perversely get a temporary lift."

"Medium and long term it is bad news, because as I said, the whole European integration process is at risk. Exit from the EU could become a more likely event as a result of the technically completely unrelated risk of Grexit."

As for the spillover effect on the Federal Reserve's timetable for interest rate normalization, the U.S. central bank can only respond to events as they unfold, he said. If Greece and its creditors kick the can down the road and eventually mint a new funding program, the Fed will proceed with plans for its first rate hike in nine years as if nothing happened, he said.

However, if the process blows up in Greece, scared investors will flood into the dollar, sending the greenback through the roof.

"That itself would become a seriously dampening factor to the U.S. expansion. As well, it is an inflationary factor," he said. "If it were actually to materialize, the safe haven demand for the dollar could cause the Fed to pause."