European leaders are working around the clock to prevent a Greek default — as if they had a choice.
European leaders have been scurrying around for quite some time in an effort to prevent a Greek default. But all the activity has obscured two fundamental questions: Is it even possible to prevent Greece from defaulting at this point? And would a default really be as calamitous as so many seem to think?
European officials certainly appear spooked. They have agreed to a €130 billion bailout package and are now talking about increasing it to €145 billion if the Greek government implements austerity measures and private holders of Greek sovereign debt voluntarily agree to steep reductions in both principal and interest. They have been hatchingschemes to keep the European Central Bank (ECB) from having to join private investors in taking a loss on its Greek bond portfolio. And they have been erecting a massive firewall of liquidity through the European Stability Mechanism, the International Monetary Fund (IMF), G-7 central banks, and the ECB in the event that markets dry up and eurozone countries and banks need cash. So far this week, Greek political leaders have failed to satisfy the demands of the ECB, IMF, and European Commission for the implementation of proposed austerity measures.
Why so much sturm und drang? What’s the alleged downside of a Greek default?
For one thing, the ECB would have to write off €55 billion in Greek sovereign debt, which would reduce the central bank’s ability to meet liquidity needs. The losses would have to be replenished by additional contributions from member governments (i.e. Germany).
For another, European banks would have to write off their own €50 billion in Greek debt, which might reduce bank capital to dangerous levels and scare off short-term lenders. Without sufficient liquidity, banks would be unable to pay off short-term debt as it matures. They might then either fail outright or be bought out by national governments (i.e. nationalized).
Other financial institutions would be in jeopardy as well. European, American, and Asian insurance companies would have to pay out on credit-default swaps (insurance) to investors who have hedged their bets against a Greek default. This might leave such companies vulnerable to dangerously low capital reserves and potential bankruptcy, with possible knock-on effects.
But the most terrifying consequence of a Greek default may be the contagion effect, in which the bonds of other relatively suspect economies — Italy, Portugal, Spain — come under attack and create liquidity problems that lead to sovereign bankruptcy.
These scenarios, however, rest on the faulty assumption that there is a choice of saving Greece from default, even though numerous studies suggest otherwise. They indicate that Greece will default despite the best intentions of European leaders. The country’s debt burden of 160 percent of gross domestic product (GDP), combined with its failure to rein in public spending and an economy that has been shrinking for five years, make default a virtual certainty. Banks lend money to those who need time, not those who need money. And Greece cannot repay its debts, no matter how much time is allotted. The question, then, is whether Greece defaults sooner or later. Later may give European leaders time to buttress a firewall against further contagion. But it could also lead to a colossal waste of resources by throwing good money after bad.
All of this begs the question: Why not just let Greece default? If Greece is a terminal patient, why not save€145 billion in bailout funds for healthier patients? Injecting Greece with euros is a palliative measure that relieves suffering but does not cure the patient, merely delaying the inevitable instead. The eurozone remains in critical condition as long as Greece continues to drift in and out of consciousness on life support.
In the grand scheme of things, Greece is relatively small potatoes. Its economy is less than one-tenth the size of Germany’s and accounts for only 2 percent of the eurozone’s GDP, and its €350 billion in debt amounts to only 4 percent of total eurozone debt. The tail is wagging the dog. Granted, there is a possibility that contagion will spread and deplete the liquidity of other euro members, but this is a remote and manageable risk.
The more likely fallout from a default would be Greece dropping the euro. Without the possibility of external funding, the government will have to cut public spending to no more than tax revenues permit. But tax revenues will be in free fall because of capital flight, a taxpayer revolt, and a rapidly contracting economy. Austerity measures will be necessary, but no government will last long enough to put these measures into effect. Faced with such catastrophic economic failure, Greece will have no choice but to return to the drachma.
Fear of contagion is essentially built on a domino theory. Back in the 1970s, the lack of predicted consequences following the American defeat in Vietnam falsified the domino theory in the realm of international politics. Communism did not spread to neighboring countries, nor did the United States have to defend its borders along California’s coast. Now it is time for Greece to falsify the theory in the realm of international economics. The firewall that European leaders have been building over the past year is designed precisely to isolate other eurozone countries from the effects of a Greek default. It is meant for those countries that face a liquidity problem, not a solvency problem. Greece is a different matter; it is insolvent. Until the gangrenous limb of Greece is amputated from the eurozone body politic, contagion will spread to countries such as Italy, Portugal, and Spain, which will kill off the euro.
All of this, of course, assumes that eurozone states will harmonize their policies regarding pension reform, unemployment insurance benefits, and public sector spending cuts to achieve reasonably balanced budgets. If not, even without Greece, the euro is finished.
There are at least two other major caveats to a recovery of the eurozone, both of which remind us that the euro is essentially a political project, not an economic one. In France, all bets are off if the Socialists win presidential elections this spring. Efforts to reduce government spending at the expense of public sector unions would cease. Cooperation with Germany on fiscal discipline and austerity measures would go out the window. And the euro would disintegrate.
In Germany, Chancellor Angela Merkel is already pushing the envelope. German taxpayers will only do so much to pay for the sins of their more profligate neighbors. Although European politicians are reluctant to confront the prospect of a Greek default, European publics are not. Street demonstrations against austerity measures in Athens have produced equal and opposite reactions in Berlin, where Germans are demanding an end to the regime of bailouts and “too big to fail.” Faced with this grassroots resistance, parties in the Bundestag are already refusing to consider additional funds for Greece. Merkel and her Christian Democratic Union coalition must listen to these demands or face the wrath of voters. If pushed too far, Merkel’s government will collapse. Its replacement is likely to be both less cooperative and more intransigent on the issue of the euro.
If the European debt crisis has taught us anything, it’s that the era of easy money is over. To ensure the eurozone’s survival, the ECB will have to make new distinctions between national bank borrowers. Banks from countries with low credit ratings (southern tier) will have to post higher quality collateral than banks from countries with high ratings (northern tier). Portuguese, Spanish, and Italian banks must no longer be permitted to use their sovereign debt as collateral for new loans.
This restriction will inhibit the kind of unlimited credit expansion that led to the real estate bubbles in Ireland and Spain and extravagant public spending and chronic budget deficits in Greece, Italy, and Portugal that spawned the current crisis. It will enforce market discipline on states that routinely run budget deficits or embrace unproductive economic policies. Such discipline will reduce overall sovereign debt and strengthen bank balance sheets. The risk of sovereign default will be transferred from eurozone taxpayers to private investors. This reform is not a panacea, but in the absence of full economic and political integration, where a European identity is sufficiently advanced to allow transfer payments from one nation’s citizens to another’s, it will have to do.
Mark S. Sheetz is fellow in international security at the John F. Kennedy School of Government of Harvard University. He is currently writing a book on France, Germany, and the transformation of Europe.
FEBRUARY 6, 2012