If Greece Quits The Euro, What Does Europe Need? Growth And Cash

By Abram Brown

Jitters about Europe can be forgiven. In fact, they're rightly warranted.

The chances for a Greek exit from the eurozone have dramatically increased in the past few weeks, Barclays economist write in a new note. Hellenic politicians failed to cobble together a functional government, forcing another round of elections on June 17. This gives fringe party groupsâ¿¿those opposing Greece's austerity and bailoutâ¿¿a chance to take control. If they do, Greece is likely to leave or face expulsion from the eurozone.

The problem? A Greek exit would be a messy, torrid affair, beneficial to none."The costs (and the risks) for Greece and Europe greatly exceed the benefits," the Barclays group write.

Economists, bless their analytic hearts, possess the greatest talent for understatement since P.T. Barnum and his circus promoters.

While you wouldn't know it from today's tradingâ¿¿and its Facebook euphoriaâ¿¿the markets have been ravaged by Greek fears since the lackluster May 6 election. Both the Dow Jones industrial average and the S&P 500 have lost 4.4%. The Nasdaq composite lost a bit more, falling 4.7%.

Financials have been among the worst performers. Bank of America dropped 9.8%. JPMorgan Chase retreated 20%, giving up all its 2012 gains. Goldman Sachs fell 10.9%.

It was a similar situation for industrials. Caterpillar dropped 9.4%. Boeing declined 7.9%.

With a Greek exit looking ever more likely, eurozone politicians will be viewing their options. Contagion across European banks and capital markets remain the greatest risk from a Greek departure. Financial institutions could topple, one following another like dominoes. First Spain, then Italy, and next⿦

"Spain is facing a sudden reversal of acpital flows that may very accelerate if Greece exits," the Barclays economists write. "And Italy is unlikely to escape unscathed if the situation in Spain worsens."

To plug the holes, the European Central Bank would need to start printing money. Lots of money. "The euro area would need to act forcefully to stop contagion," the economists write. "This will possibly require at the minimum the ECB to provide as much liquidity as needed for as long as needed."

Past that, Europe should consider replacing austerity policies with growth measures. In a separate note today, Goldman Sachs economist Lasse Nolboell W. Nielsen  lay out a (convincing!) case for expanding an economy, not paring its parts.

Greater consolidation leads to greater overall economic deterioration, Nielsen says. A fixed exchange rate complicates the situation, removing the cushion on exports from a depreciating exchange rate. In general, a country should not look to cut any more than 3% to 4% of gross domestic product in the short term, Nielsen estimates. Spain expects to cut some 4.5% of GDP; Italy sees cuts amounting to 3.5% of GDP.

But longer term consolidation and cut backs, such as improving governance and constraining politicians' discretionary power, makes sense.

"Our research suggests that the challenge of achieving external and fiscal balance is very large in the Euro area," Nielsen says.

And, yes, that's understating the situation.

Reach Abram Brown at abrown@forbes.com. Or follow him @abebrown716.


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