Why the US will weather a Greek exit

If Greece leaves the euro, the US economy could easily slip into recession, but given the long-term consequences of Europe struggling with a currency regime that makes little sense, that cost is worth bearing.

Essentially, Athens would exchange drachma for euro in circulation among its inhabitants, remark private debts and bank accounts to drachma, and until conditions stabilised, limit withdrawals at Greek banks and capital outflows.

As the drachma fell in value, Greek exports would increase, reducing unemployment. Consumers and businesses, with their debt redenominated into a cheaper currency, would enjoy a windfall and spend more. All would help lift the Greek economy out of crisis, but this can only happen if Germany and other European governments cooperate.

The money Greece owes other governments, the European Central Bank and International Monetary Fund under international law can only be remarked to drachma with their consent, but that debt is too substantial for Greece to repay in euro.

The disastrous consequences of German repartitions after World War I should compel European leaders to accept payments in drachma. The accompanying losses are manageable, but concerns about contagion will require that capital controls and additional ECB support be immediately deployed to banks in Italy, Spain, Portugal, and perhaps Ireland.

Uncertainty breeds panic, and even with these thoughtful measures, the euro will continue depresse, and the overall European economy is not likely to grow for a year or two or may even contract by 1 or 2 percentage points.

Europe is an important market for US exports and those will stagnate. Just as importantly, US banks and investors will take a hit from a further declining euro and reduced European bank lending activity in the United States and in countries that buy American products. Overall, expect US growth to slow by 0.5 to 1 per cent from the fallout of Greece leaving the euro.

By itself, that is not enough to sink the US economy. Forecasters are predicting growth of about 2.5 per cent for 2012 and 2013, but most have assumed the president and Congress reach some kind of compromise on the large federal spending cuts and tax increases that will trigger on January 1.

Even if President Obama is elected, he will likely still have a strongly Republican House. Emboldened by their November triumphs, neither side will be in the mood to do much compromising, but they will find some creative way to kick the can. If Obama is a lame duck, double that assessment, and Mitt Romney, constrained by the lack of 60 Republicans in the Senate, would not be able to accomplish much more immediately.

Business uncertainty in this climate make the 2.5 per cent forecast unrealistic, amid all this international and domestic turmoil, and a 1 per cent hit to US GDP growth from a Greek exit from the euro could easily slow US growth to less than 1 per cent. That is too weak to be sustained, and a recession could easily result.

Still, after a year or two, Europe would re-emerge, and that would improve US long-term prospects – a prosperous Europe is critical to American prospects. The alternative in Europe is continued turmoil and stagnation, or long-term contraction and decline, as it tries to make an unworkable currency regime work. The long-term economic and security consequences for the United States are too negative to willing accept.

The euro has failed, and time has long passed for Greece to bail out. Sooner or later, Spain, Portugal and perhaps Italy and Ireland, will have to follow, but after the world does not end with Greek withdrawal those would be easier and less painful decisions to manage.

The euro was a bad idea with the best intentions, and now the sensible course for all involved is to cut losses and return to the sanity of national currencies.

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland.

Follow Peter Morici on Twitter @pmorici1