CANNES, France (Reuters) - It may well be remembered as the day the euro zone began to break apart.
At a late night news conference in Cannes on Wednesday, German Chancellor Angela Merkel and French President Nicolas Sarkozy shattered the bloc’s most sacred taboo, conceding openly for the first time that Greece might end up having to leave the tight-knit currency club it joined a decade ago.
The admission, after an intense two-hour meeting with Greek Prime Minister George Papandreou on the eve of a G20 summit, sets the euro zone on a perilous course that could reverberate in Europe and beyond for decades.
Were Greece to leave the euro zone, a step that until now European officials have said is technically and legally impossible, the consequences would be devastating even though the country represents just 2.5 percent of the 17-nation currency area’s gross domestic product (GDP).
Just how devastating is difficult to say because the move would take Europe and the global financial system into uncharted territory.
But what does seem clear is that an exit would spark contagion to other peripheral countries as foreign investors pulled out en masse. This in turn would hammer financial institutions across the bloc, leading to bank runs and forcing the European Central Bank (ECB) to respond with massive liquidity provisions and government bond purchases.
The central bank and all private and official sector creditors would have to write off their claims on Greece in one fell swoop. The resulting credit crunch, economists say, would make the freeze-up that followed the 2008 bankruptcy of U.S. investment bank Lehman Brothers seem mild.
“If Greece left the euro, the market pressures on the countries perceived as the next most vulnerable would rapidly become overwhelming,” the Economist Intelligence Unit said in a recent report entitled “After Eurogeddon.”
“As the chain reaction spread across Europe, we think contagion would be rapid, dramatic and uncontrollable at times.”
Beyond the harrowing financial consequences, the move would also be a crushing symbolic setback for Europe. After more than half a century of closer integration, it would open the door to a new era of disintegration.
Merkel herself has said an exit would lead to a devastating “domino effect” across the euro zone.
“Not a single person would put their money in Europe anymore,” she said in late September.
This is what makes her and Sarkozy’s about-face in Cannes so significant.
German officials said Papandreou’s surprise call for a referendum on the latest EU/IMF rescue package for Greece -- a move that sparked widespread panic in global financial markets -- was the final straw for the German and French leaders.
Frustration with Papandreou’s government has been building steadily since the bloc first bailed out Greece in May 2010. Since then Athens has failed repeatedly to meet the fiscal targets set for it by its international lenders.
Against hopes, its economy has also nose-dived. It is expected to contract by over 5 percent this year and by 3 percent next year in what would be its fourth straight year of recession. Unemployment has skyrocketed.
It is this economic collapse that has sapped popular support for Papandreou’s government and the austerity-for-aid rescues from the EU and IMF.
Papandreou’s referendum call reinforced the idea in major European capitals that Greece may be too far gone to save and its political leadership not credible enough to back up with billions more euros in taxpayer money.
On Thursday, the Greek government appeared to be on the brink of collapse. Sources in Papandreou’s Socialist party told Reuters that lawmakers were forging a proposal for a new coalition government headed by former ECB vice president Lucas Papademos. The prime minister’s chief of staff said he had not resigned and had no plans to.
Regardless what happens, political and social turmoil in Greece looks sure to continue unabated. The resulting uncertainty will undermine confidence in the euro zone’s ability to get a grip on the crisis.
The costs of keeping Greece in the euro, some European officials now believe, may outweigh allowing it to leave.
“The euro as a whole must remain stable,” Merkel said on Wednesday night. “We would prefer to ensure this with Greece rather than without it. But the top priority is stability.”
An ECB working paper published in December 2009, just as Greece’s dire fiscal problems were coming to light, concluded that withdrawal from the monetary union without a parallel withdrawal from the broader EU would be legally impossible -- a view that was backed up by the European Commission on Thursday.
But even the Germans admit that Europe’s obligations to Greece would not end if it were to leave the currency bloc.
One senior official told Reuters on condition of anonymity that the disorderly default that would result if Europe refused to give Athens more aid would lead to a bank run within 48 hours, a mass flight of capital and Greek citizens abroad, and instantly halt all money transactions by the Greek government.
That could force Europe to fund core services such as healthcare and water. A euro zone exit would make things even worse.
“You would have to ship truckloads of euros to Greece on the sly” to prevent social implosion, the German official said, noting the EU had been forced to take similar steps in Bosnia and Montenegro, and the United States in Panama.
All this means that Europe is likely to do everything in its power to avoid a Greek exit, even if it has now come around to the idea that it could happen.
“As far as we’re concerned this is the only option that is on the table,” a European Commission spokeswoman said on Thursday.
But ultimately it will be up to the Greeks, as Merkel and Sarkozy made clear in Cannes.
Writing by Noah Barkin; editing by Janet McBride