INSTEAD of asking the question, "What to do with Greece?", one should instead ask the question “What policy regime should we implement with respect to insolvent countries?”. This would probably lead to improved answers to the first question.
The current policy regime is plagued by two taboos and one fiction. The two taboos: 1) The euro is not renegotiable; 2) A euro-zone country cannot formally default on its public debt. The fiction: there is no moral hazard problem.
In fact the moral hazard problem is huge. Vice is rewarded while virtue is punished. The International Monetary Fund (IMF) and European Union have created a pool of money to be tapped by those countries that most successfully put themselves in trouble. And the two taboos make it likely that more money will come to the table, once the initial manna is exhausted. Why should governments avoid taking over private debt if they know they can claim rescue money from their fellows? Equally, public sector unions would be foolish to accept pay cuts as long as their wages can be financed by benevolent tax payers from abroad.
To exit this conundrum, the two taboos must be overturned. A haircut must be imposed on debt holders, so as to make sure that in the future the possibility of default imposes market discipline upon sovereign states.
When a country defaults on its sovereign debt, it loses access to international capital markets for a while. Greece, Spain, and Portugal have a competitiveness problem. Their real exchange rates are overvalued and they are running large trade deficits. These deficits are financed by an inflow of capital (loans) from abroad. If Greece defaults, it will have much more trouble borrowing abroad and will no longer be able to finance large trade deficits. To restore its trade balance, its real exchange rate will have to depreciate. This means that Greek goods have to become cheaper and that Greek wages have to fall relative to the rest of the world. This painful medicine was traditionally administered by the IMF when it was rescuing a country: restoring a competitive exchange rate was one of the main aspects of IMF adjustment programmes [part of the Washington consensus]. The question is: how do you engineer a quick real depreciation when you are part of a currency union?
One possibility is to mimic its effect through tax policies. A fall in social security contributions matched by an increase in VAT would do the trick. But this requires high tax enforcement [which is notably weak in Greece] and can only go on as long as there are social security contributions left to be reduced. If this turns out to be too difficult, one could consider a return to the drachma with a flexible exchange rate regime. This will have the advantage of allowing for future depreciation when needed, if it turns out that Greece has an endemic tendency not to balance its accounts. With the drachma, there would be no drama.