If the Greeks leave the Eurozone, it would be awful. Both Greece and the remainder of the euro area would experience damaging volatility and uncertainty. But "Grexit" does not have to be all bad. In fact, if the Eurozone countries use the crisis to push through long-needed reforms, they could wind up in a much stronger position in the long run.
The Eurozone faces two related challenges. The first, fundamental challenge is that the single currency arrangement lacks the tools to maintain economic synchrony across diverse economies. The political cost of sacrificing fiscal independence has always stymied efforts to build features like burden-sharing arrangements between countries.
The Global Financial Crisis revealed the consequence of this shortcoming. It ripped through the periphery economies, but left core countries in much better shape. With only one Eurozone-wide interest rate to respond, the ECB was unable to avoid the eruption of what we now know as the Eurocrisis.
A second challenge has now come to the fore, as Greece plays high-stakes poker with the European Commission. Agreement to exceptional treatment for Greece risks establishing a precedent that Eurozone rules can be broken. Failure to reach an agreement could mean Grexit.
The first structural challenge clearly set up the second Greek bailout challenge. But now capitulation to Greek demands would feed back to exacerbate the structural challenge. Not only would Eurozone institutions be inadequate, but they would have weak authority. This is not a tenable outcome for the Eurozone.
Grexit would be better. Clearly it would create a chaotic situation in Greece that would make things worse before they got better. However, reasonable economists can debate whether staying in the Eurozone with a too-strong exchange rate and high debt would be better for Greece. In any case, the ball is in Greece's court to make this decision, so presumably they will choose the option that they feel works best for Greece. God speed.
For the Eurozone, the biggest risk from Grexit is that membership appears optional. Despite all laws and institutions designed for permanence, any member - even Germany - could be viewed as having one eye on their own exit should some economic disjuncture become unbearable. Moreover, domestic euroskeptic parties would surely try to capitalize on the momentum provided by Grexit. The Eurozone would face a true risk of break up.
Yet, much as they may like to entertain the idea of greater national autonomy, the average European does not at all want to see a total break up of the Eurozone. This is a key fact. Faced with the bald reality of that scenario, it is reasonable to imagine that panic will set in and support will shift massively to the side of Eurozone solidarity.
The Eurozone has been in need of just such an existential crisis to provide the proverbial kick in the pants to its members to commit to greater fiscal burden sharing. If European leaders play their cards right, they can leverage this shift in sentiment to overcome previous political hurdles to greater fiscal integration.
Stronger fiscal arrangements would make the Eurozone much more durable. In that sense, it could serve as an effective adhesive applied to the perceived cracks Grexit would create. It may remain true that exit is an option for remaining members, but stronger fiscal arrangements reduce the economic disjuncture that makes exit attractive. The door may be open, but everyone takes a big step back away from it.
The question then becomes what form the fiscal burden sharing arrangement takes. The new fiscal compact, currently being tested by France's request for forbearance, is insufficient. While Greece's problems (absent the accounting fraud) might have been limited by a fiscal compact, neither Ireland nor Spain would have been saved.
A minimum requirement is greater financial safety nets. Eurozone members balked at creating area-wide deposit insurance two years ago. Instead, ECB-led supervision with a bailout fund is a step forward, but not quite there yet. The European Commission envisions a process of deepening of fiscal integration culminating in an autonomous Eurozone budget with automatic cross-border fiscal stabilizers.
The best outcome would be for Greece and the European Commission to find a bargain that preserves the integrity of Eurozone discipline and meets Greek demands for less austerity. The scenario in which Grexit results in a stronger fiscal union among remaining members is very risky. It assumes leaders are able to perform political judo in managing the popular reaction to Grexit.
But given the choices the European Commission faces, this strategy may not look so bad. If played right, Greece leaving the Eurozone could ironically result in a more robust, more viable currency union than they have today.