The fiscal situation in Greece is very dire. Greek Prime Minister George Papandreou introduced drastic austerity measures where both government spending were slashed and taxes were raised. Correspondingly, both of these actions caused Greek’s economy to take a dive and resulted in revenues falling. That only made their fiscal deficit widen. Therefore, shouldn’t Greece just default on the debt?
Consider the distressed household, who recently lost their primary source of income and amassed a vast array of debt ranging from a large mortgage, clothes, electronics, vacations, and household appliances. At the very moment that these bills are starting to come due, their access to further credit has been shut off. In addition, these various creditors are not only asking for regular payments, but are demanding that their balances be paid off within a year. Think about a mortgage exceeding 200,000, credit card debt of $20,000, and a household income that has been slashed drastically from $100,000 to $20,000. Given this scenario, bankruptcy appears to be the only option. That scenario is similar to Greece.
Many economists agree that Greece simply lacks the capacity to service just the interest on their debt, so why not just default? This is a question that many of the citizens and politicians of Greece are asking Prime Minister Papandreou. In fact, this is exactly what Argentina did in 2001. However, Argentina’s ability to develop monetary policy as a single entity is different than Greece.
Greece is a member of the Eurozone and their default impacts the rest of Europe. In order to keep interest rates low for Eurozone member countries, the European Union (EU) and the European Central Bank (ECB) have given an implicit guarantee that all debt obligations will be paid by each member. If Greece reneges on this debt, then that will trigger panic by global investors. They would no longer have faith that similarly debt-challenged EU members will pay their debts, so that would raise their borrowing costs. This could mean similar defaults for Ireland and Portugal.
That series of events would be a worst case scenario that would not only have serious implications for Europe, but the U.S. and the rest of the world. At a minimum, a Greek default would total $485 billion, but would likely be much more when taking into account credit default swaps that would be executed. Credit default swaps are investment products purchased by investors, who are betting that a country will default on their obligations. If Greece does default, then the solvency of European financial institutions would be in question as they could be on the hook for unknown multiples of that amount, as they pay up on the losing side of the credit default swap. This could easily cause a global-wide recession that would probably not exclude the U.S.
There is a feeling within the global economy that Europe realizes that Greece is too big to fail, which can create a moral hazard. The moral hazard is that this implicit guarantee of the EU, ECB, and the International Monetary Fund (IMF) will result in Greece never seriously addressing their fiscal imbalances because they realize they will be bailed out. Therefore, Greece continues to believe they can negotiate more favorable repayment terms without having to go through more painful government spending reductions and tax increases.
The downside to Greece depending on an expensive bailout is the political fallout for Germany, France and other European countries from their citizens. Any bailout would eventually come from taxpayer dollars, so that makes it a very difficult sell for German Chancellor Angela Merkel and French President Nicolas Sarkozy. Their political fate limits their flexibility in dealing with Greece, so it is uncertain how far they will go in working with Greece.
As for the bond holders of Greek debt, history tells us that bond investors are very reticent in providing significant debt relief. If that is the case, then that places more pressure on European and IMF officials to funnel more funding to them. However even if the bond investors accept huge losses, this would impact future financing of other activities. Many of the bond holders are financial institutions and large institutional investors, so any losses means less liquidity. Less liquidity results in less credit available for businesses and consumers. This drives up interest rates and drives down economic activity.
As one can see, there are not too many attractive options here. It appears the best option is for the EU, ECB, and the IMF to step in and pay off the bond holders, but that would create a precedent that could involve bailing out Ireland and Portugal, along with possibly Italy. That is potentially a very expensive solution that would severely impact the economic performance of Europe into the future. Even with that awful scenario, allowing Greece to default could set off even more cataclysmic results.