Forget about Greece for a moment. Just think about country X, which has lived well beyond its means for years thanks to loans from inattentive or foolishly optimistic lenders. When the crunch comes, the X-people will have to cut back on spending. And the X-lenders will generally suffer from the famous rule of banking: “Can’t pay, won’t pay.”
If Herman Van Rompuy, the president of the European Council, has his way, Greece is not going to be country X despite its weak government, bloated civil service and poor trade position. Van Rompuy said on March 25 that a vague new support agreement should “reassure all the holders of Greek bonds that the euro zone will never let Greece fail”. This default taboo should be reconsidered.
True, the Greeks might manage to tough it out. But it won’t be easy, even if the EU, the IMF and foreign investors are willing to help. A near miraculous economic recovery is required: from sharp recession and falling wages to fast growth. The euro makes the task more difficult, because Greece cannot stimulate growth through devaluation.
A limited default — rescheduling combined with modest write-downs — would make the task more manageable, besides appropriately punishing risk-blind lenders and complacent politicians. But Van Rompuy and many investors fear a sovereign default would start a chain reaction of panic and failures, perhaps breaking up the euro zone.
The worries are certainly not groundless, even if Greece’s 270 billion euros of debt is only 4 percent of all euro zone sovereign obligations. A write-down could reduce Greek banks to insolvency. Other fragile European banks would suffer. Other weak sovereign borrowers might follow, intentionally or not, creating a cascade of traumatic defaults.
But carefully planned debt write-downs could actually be less destabilising for markets than a long wait to see if Greece can struggle through. The uncertainty is distorting the euro zone’s politics and the euro’s value. A solution, even a bitter one, would calm nerves. And the risks of a Lehman Brothers II meltdown could be reduced by a three-pronged preparation.