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Greece: The anatomy of a default

May 16, 2012: 10:29 AM ET

The mechanics of shelving the Euro for its own currency are pretty predictable. Here's what's likely to happen.

euroFORTUNE -- Everyone from Greece's squabbling political parties to Europe's central bankers are expressing faith that Greece will remain in the Euro. That's not surprising, since simply talking about how to manage an exit would spread panic, making the exit inevitable. But the panic is already here. Greece's departure from the Euro could happen within a couple of weeks, if not a few days.

The pressing problem isn't a splintered legislature that may balk at delivering the reforms that the IMF and European Community are demanding in exchange for the next tranche of bailout money. It's a disastrous, old-fashioned run-on-the bank. "For a year, Greeks have been sending their savings from Greek banks to foreign banks," says Robert Aliber, retired professor of international economics from the University of Chicago. "Now, the flood has reached a crescendo." Indeed on Monday alone, outflows from the Greek banks reached almost $900 million.

The flight of capital is sapping the deposits needed to refinance mortgages and small business loans, causing a full-blown credit crisis. Greeks are also extremely reluctant to spend their Euros on cars, dining or anything else, since they reckon those Euros will buy more at the supermarkets and auto lots in the weeks or months ahead. The disappearing consumer is further crippling the economy.

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Greece's exit is absolutely necessary. "Its prices and costs are far too high under the Euro, so it just cannot compete on international markets," says Aliber. "The Greeks have suffered far more through all these misguided bailouts than they've gained by lowering prices or costs." The political gridlock, argues Aliber, is actually a good thing because it will hasten abandoning a disastrously overvalued currency, just what's needed to get Greece growing again.

The mechanics of shelving the Euro for its own currency are pretty predictable. One day soon, imagine it's late on a Friday afternoon, the Greek government will declare all banks closed for the following week. By Monday, the legislature will vote an emergency law that designates a fixed exchange rate of, say, 1 drachma –– the Greek pre-Euro currency –– for each Euro. By Monday, all corporate and personal savings in Greek banks will be denominated in drachma.

The drachma will tumble in value, so that almost immediately, Greek consumers will need at least 1.5 Drachma to buy one Euro. A savings account that held 15,000 euros is now 15,000 Drachma. But those drachmas will soon fetch just 10,000 Euros. That's a "devaluation" of 33%. "That number is the low-end of the range for countries that exit a common currency," says Uri Dadush, an economist at the Carnegie Endowment.

What happens next is the pivotal issue, and top economists disagree strongly on Greece's post-Euro future. To be sure, this isn't a play by Aeschylus or Aristophanes where the audience knows the finale. Yanis Varoufakis of the University of Athens foresees a Greek tragedy in which a run on the banks is followed by a run on the drachma. "Greeks paid in drachma will go to the ATM then immediately exchange their drachma for Euros people have stashed in their freezers," says Varoufakis. He thinks that the drachma will keep plunging against foreign currencies, and Greeks will keep bailing, causing a new crisis of hyperinflation.

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But the disaster scenario isn't inevitable. "Other countries have left what's effectively a common currency zone without suffering hyperinflation," says Hans Humes, president of investment firm Greylock Capital, which holds Greek government bonds. Aliber thinks that Greece's exit will create the same growth dynamic that's recharged Iceland and Argentina, both of whom effectively shed overvalued currencies.

My view is that the relatively optimistic Aliber forecast is the more likely outcome. Here's how it plays out: In the first few days after the drachma's return, much of the savings that left the country in Euros will come back. Greek goods will be screaming buy, selling for at least one-third less that a week before for people exchanging their Euros for drachma. That sudden inflow will support the drachma.

Overnight, Greece will once again become what it was in pre-Euro days: an inexpensive country. Tourists will cancel their vacations in Turkey –– which a few weeks ago were the Mediterranean bargain –– and tour the Greek islands instead. Exports of Greek tomatoes, olive oil and fish from its fish farms will expand, and imports of manufactured goods will fall as they rise in price versus domestically made products.

Greece will also default on its sovereign debt, another necessary step towards recovery. The European Central Bank will suffer big losses, but private bondholders have already taken most of the pain. "We've taken an effective 80% haircut on twenty different maturities of Greek government bonds," says Humes. "I do not see a reason for an additional haircut."

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The move that both Greek and European leaders so dread will restore modest growth. But it will also restore the same negatives that saddled Greece before it entered the Eurozone on January 1st, 2001. "The question for the future is whether we see a new or an old Greece," says Aliber. The former would require that the Greek government junk monopolies, trim the gigantic public workforce, and shed anti-competitive rules that prevent cruise lines from starting and ending trips in Greece. If Greek productivity lags that of its neighbors, it will import more and export less, hobbling wages and the living standards of its workers. To restore its competitiveness on global markets, it will have to keep devaluing the drachma at regular intervals.

That was the old Greece, and unfortunately, it's the old Greece that's more likely to emerge. But at least will escape the grip of a currency that's at least 50% overvalued. Europe is about to let the market, not politics, decide what price it make its vacation packages and agricultural bounty a great deal again. And it will happen soon.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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