Greece has no good options. Without question, Greece brought debt problems on itself – this is the consequence of politicians using irresponsible fiscal policy to win elections.
As the International Monetary Fund put it when Greece became the first eurozone country to borrow from the fund in May 2010, “Even with the lower deficits envisaged under the program, the debt as share of GDP will continue to peak at almost 150 percent of GDP in 2013 before declining thereafter.” The situation has not improved in recent months – even under the most optimistic scenario, the debt-GDP ratio will peak above this number.
The problem is that loose talk among European leadership of potentially “restructuring” or “reprofiling” Greek debt creates more problems than it solves. Financial markets fear another Lehman moment, in which authorities decide to let a significant borrower fail – without fully understanding the consequences.
Who in the private sector or the various responsible governments or at the IMF can tell you exactly what would happen – and to whom and where – if Greece were to default in any fashion?
European banks have very low levels of capital, meaning they are highly leveraged – having a great deal of debt relative to their equity. They are not in a position to withstand losses on their large portfolios of European government securities if, as seems likely, Greek problems cause a fall in the market price of Spanish, Italian, Belgian, or other eurozone sovereign debt.
The banks convinced themselves – and their regulators – that lending to all these governments was “riskless”. This was the structural mistake at the heart of the eurozone. Greece and others were able to borrow so much relative to their economies because creditors believed this debt was very nearly just as safe as German Bunds.
European politicians are now choosing between what they see as three options (a) restructure Greek debt, take big losses at French, German and other banks, and deal with the systemic consequences on the fly, (b) provide additional financing to Greece, allowing them to run for another five years without having to come back to the private markets, (c) muddle through, with various promises of further fiscal adjustment, quick privatization, and greater structural reform from the Greek side, while really just hoping that a sufficiently strong global growth boom will lift all ships.
The right approach would be to deal with all troubled eurozone sovereigns and global vulnerable banks in the same pan-European package of debt restructuring where appropriate, fiscal adjustments as needed, and improvements in competitiveness for all countries that have consistently been running current account deficits.
But there is a nearly zero probability for this course of action. European politicians understand the issues just fine, but they do not want to face the electoral consequences that would follow from acknowledging the currency union was poorly designed and implemented.
An edited version of this post appears on the NYT.com’s Room for Debate: Is there any hope for Greece’s debt problem? See that page for alternative views of what Greece could or should do.