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What if Greece defaults?

In News on June 20, 2011 at 12:47 pm

Greek default a.k.a. Lehman brothers II? 

Eurozone ministers meeting in Luxembourg over the last couple of days, agreed on a second bail-out for Greece. They acknowledged the fact that Greece cannot borrow from the international markets and have on principle agreed on a second aid package. But they have postponed a €12 billion EU/IMF loan (and last payment of the €110 billion aid package which was agreed in May 2010) for mid-July, and on the condition that the Greek parliament agrees on the new austerity programme. Without this new loan, Greece will not be able to make debt payments. So, what Europeans in effect did was to create even greater pressure to the Greek government to approve the greatly unpopular measures, which foresees privatizations of €50 billion until 2015.

The greatest fear shared between market analysts and politicians across Europe is a Greek default. Earlier this week, as Greeks were demonstrating on the streets against the austerity measures and Europe’s leaders were indecisive regarding the form of the Greek bail-out, the fear of default spread across financial markets.

So, what if Greece defaults? First of all, there will be a shockwave spread in the banking sector in Greece and Europe. Greek banks will lose billions as they hold a great part of the Greek debt and they will immediately be downgraded by credit rating agencies. French and German banks will also lose billions of euros, as they are also greatly exposed to the Greek debt (€56 billion and €34 billion respectively). (Here there is an overview of which banks are exposed to the Greek debt). The greatest fear lies in the unknown. What if there is a so-called “Lehman Brothers moment”, when the financial markets panic and the lending taps are closed?

As Greece defaults, the perceived risk of Portuguese and Irish bonds will increase, which will lead to a massive sale of these assets by foreign investors. The same thing, to a smaller extent, will happen to the cost of borrowing for Spain and Italy, as doubts are increasing over about the sustainability of their debts. More importantly, the Greek default will have now set a precedent. So, other highly indebted European governments, also pressured by their electorates and public opposition, may start considering the option of default. It doesn’t matter if these governments would not actually consider this option. For the financial markets and the credit rating agencies, it matters that the option is now on the table.

The third repercussion of the Greek default will be that for the first time in the European Union’s history, European integration will unravel. European integration has stalled, has gone through periods of Eurosclerosis, has suffered from lack of political leadership, indecision and inertia. The European Union may be considered a two-tier, or even three-tier economic area, depending on how one reads the levels of cooperation between the countries, but never in its history has there been an actual “step back”. If Greece leaves the eurozone, European integration will have unravelled.

The consequences of a possible Greek default are the reasons why the Europeans reached an agreement on a second bail-out loan for Greece. However, postponing the last payment of the first bail-out and making it conditional on the present austerity programme is highly problematic. First, it creates huge pressures on the Greek government to pass a highly unpopular programme. Second, this will only represents a short-term solution. The magnitude of the Greek debt remains. The debt is now heading towards 153% of GDP. There are many economists who argue that the question of Greece defaulting on its debt is not “if” but “when” (whether now or in 2015).

The austerity programme which was agreed last year simply did not work. And why would it? How can a shock austerity programme, which depresses aggregate demand while the government cannot devaluate its currency, be successful? Unemployment has gone up to 16%. The Greek economy shrunk in 2010 by 4% and industrial production decreased by 11%. How can a new austerity programme, which will follow the same rationale work on an already depressed economy?

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