It is pretty clear that Greece, and Europe, face an untenable situation. That conclusion should hardly be startling. However much European Union (EU) officials deny it, default forms the basis of virtually every headline on European finances.
Certainly Greece, which adopted more austerity measures in June, will default without substantially more help from the EU or the International Monetary Fund (IMF) or both. Worse for Europe, a Greek default threatens fear of contagion about other, already precarious, members of the union — Ireland, Portugal, Spain, Italy and more recently, even Belgium. In many characterizations, people call for Greece to pay the price of its profligacy. But it is not just Greece or the vulnerable European periphery that will suffer. No matter how the situation is handled, it seems Germany and the other prosperous EU members cannot avoid the expense and the pain.
There can be little doubt that Greece has failed in every sense of the word except, so far, to default. As a result, ratings agencies have downgraded Greece's bonds to a level just shy of default.
Long before the crisis broke, the Greek government in Athens, against EU rules, had for years allowed its budgets to run unsustainable deficits, and it hid the fact from its fellow EU members . The red ink has accumulated to a huge debt overhang, amounting to upward of 150% of the nation's gross domestic product (GDP), almost twice the European average.
Greece has even failed by the standards of last year's EU rescue. When in spring and summer of 2010, Greece's fellow EU members cobbled together a rescue that, with €30 billion in standby credit from the IMF, put €110 billion at the country's disposal, Greece was unable to put its finances in order as it had promised.
Global credit markets have understandably begun to behave as if Greece will default. Credit default swaps have risen to levels approaching 1300 points for 10 years, implicitly suggesting a two-thirds chance of a Greek default some time a lot sooner. Greece now must pay 15.5% on its 10-year bonds and 23% on its two-year notes. These borrowing costs have compounded Greece's already difficult financial circumstances and prospects. At lower borrowing rates, Greece's huge debt overhang had already driven debt service costs to some 6% of GDP.
If Greece were Europe's only financial problem, the EU could manage matters easily. But, even if all solutions were to fail and Greece were to renege on its public debt, the total of approximately €350 billion would amount to only some 1.1% of the €31.7 trillion in assets held by euro area financial institutions. Also, the Greek government has a remarkably attractive real estate portfolio, amounting to some €280 billion, sales from which could alleviate a substantial part of the nation's public debt burden. In acknowledgement of this fact, privatization has become an increasingly important part of proposed remedies.
Since Greece has become the entire continent's crucial first line of financial defense, the simple option of letting markets take their course looks a lot less attractive than it might at first. There are effectively four basic options for the EU, however infinite the potential detail. At one extreme, the EU could back all Greek debt and commit to similar support for other weak countries, no doubt imposing stringent conditions on all seeking support. Even with aid from the IMF and the European Central Bank (ECB), such an approach could burden the taxpayers of Europe, most notably the Germans.
If Europe allows Greece to default outright, the people of these stronger EU nations would still pay the price. A defaulting Greece, even if driven out of the euro, the EU altogether, and forced to return to a devalued national currency, would likely lead to contagion.
Then banks in Germany, France, the Netherlands and the United Kingdom would suffer huge losses. And because such losses would threaten the stability of Europe's financial system, these governments might have to put up rescue funds.
If these stronger European nations decided to get tough all around and choose a third way in which they refuse to support either Greece or their banks, the people in these countries would still face a terrible cost. Because the ensuing financial dislocations would doubtless precipitate a difficult, perhaps crippling, recession, this approach might impose the most severe costs of all, not on taxpayers directly, but on all in these once-vigorous economies.
A fourth alternative, called a soft default, falls somewhere in between these extremes. This approach could spread losses through participants and over time by managing the losses. The proposals surrounding this alternative have multiplied recently.
One suggestion would have Greece buy back its debt. To do this, of course, Greece would need EU financing. Another possible solution would relieve future Greek financing costs by offering partial credit support from the EU, as the United States did with Latin America through "Brady Bonds." Still another aspect of a soft default would use debt exchanges of various kinds, some coercive, some voluntary.
In one, lenders would promise to buy new Greek debt as their current loans mature. Other aspects of such exchanges would relieve immediate cash-flow burdens by extending maturities, reducing coupons, maybe giving a payment holiday or even arranging payments in kind. In one respect, this sort of relief has begun, since Greece has already extended the maturity of its EU loans to 7.5 years from 3.5 years. One way or another, such arrangements would include a "haircut," which means a loss for the lenders. Though hardly welcome, lenders would certainly prefer this controlled setback to an outright default.
Because politics lies behind any decision, probably more than economics and finance, there is no telling how Europe will resolve it. Germany, despite the anger of its voters, may decide that a full Greek bailout is the cheapest solution after all. But it is clear that the status quo is untenable. Europe will have to move and, as should be clear, the cost, one way or another, will necessarily fall on Germany and the other rich countries in the EU.
Milton Ezrati is the senior economic strategist at Lord Abbett and an affiliate of the Center on Economic Growth in the Department of Economics at The State University of New York at Buffalo.