The Simplified Version of What Happens if Greece Implodes

Greece's economy peaked in 450 B.C., but its sway over world financial markets might be reaching a new high.

Regardless of yesterday's election, no one knows what will happen to Greece in the coming weeks and months. It might rebuild. It might collapse. It might leave the euro. Or something totally unforeseen could happen. No one knows. All we know is that the weakness of the country's economy and the dysfunction of its government are breathtaking.

Here's a simplified version of what's keeping people worried.

If Greece balks at the conditions of its bailout, it could be pushed out of the euro currency and back to its old currency, the drachma.

That could change everything.

A key tenet of the euro pact is that it functions like the proverbial roach motel: You join, and you're in for life. You follow the rules, and you work with other nations to solve your problems.

Greece leaving the euro would throw all that out the window, which means a couple of things will likely happen.

First, the new drachma would be worth much less than the euro, and Greeks and the country's bondholders would lose a substantial portion of their savings -- estimates of devaluation range from 50% to 70%. All debts, contracts, and obligations would likely be redenominated into the new currency. This would almost certainly happen over a weekend when banks are closed, and a bank holiday would likely be arranged to minimize chaos and allow the government and banks to sort out the details. Capital controls would likely be put in place to prevent money from leaving the country, and perhaps even border patrols to make sure citizens aren't literally fleeing with bags of cash. To incentivize people to deposit cash back into Greek banks, the government may set a favorable exchange rate linked to the euro, and promise to implement a slow, gradual exchange for new drachma.

Even with detailed preparation, this would be an ugly process. Products Greece imports -- things like fuel, medicine, and machinery -- could face drastic shortages as businesses can't pay invoices denominated in euros. UBS estimates that Greece's GDP could fall 50% if it leaves the euro. Everyone expects riots and social chaos -- what do you have to lose when you're unemployed, have had your life savings wiped out, and have lost all hope?

And that's just Act 1.

If Greece exits the euro, suddenly creditors and bank depositors look at Spain, Italy, Ireland, and Portugal with doubt. If Greece can leave, maybe they will, too, the thought goes. Scared that other countries will revert to new, weaker currencies, creditors demand higher interest rates, or cut countries off from funding altogether. After watching Greek households lose their life savings, depositors in other countries start pulling their money out of banks and hiding it in the relative safe havens of France, Germany, and the underside of their mattresses.

Both of those actions mean European banks become even more loath to lend, worsening the Continent's economic problems, which increase worries that more countries will default and exit the euro, spiraling on and on.

The one thing capable of stemming a banking panic -- a sincere government deposit guarantee -- isn't feasible in many weak European countries because their government's treasuries don't have the trust of bond markets. Banks may not be able to count on the European Central Bank for liquidity because their assets might not be strong enough to post as collateral. Existing bailout funds aren't large enough to make a measurable difference, and Germany seems unwilling to sacrifice for its profligate neighbors more than it already has. That's where things get real hairy: The rule of thumb with financial panics is that they spread until stopped. In Europe, there's not much capable of stopping them.

That's the worry, at least.

Realistically, the biggest risk is something no one foresees. There's chatter that Greece leaving the euro could bring about something like the aftermath of Lehman Brothers' bankruptcy in 2008, but that's the wrong way to look at this. "Enough with the 'Lehman Moment' obsession," New York Times reporter Binyamin Appelbaum wrote Friday. "The next crisis is never like the last one."

At the time this article was published Fool contributorMorgan Houseldoesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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