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 hatching schemes 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.