European sovereign debt fears are nothing new. We've been talking about Greece's problems for well more than a year now, and we've seen any number of plans attempting solve the crisis from any number of groups. None of these plans has worked. It is becoming increasingly clear that Europe needs to accept that Greece is bankrupt and that a default will be necessary. Indeed, this will be a painful process. However, it could help remove the incredible uncertainty that is rocking the markets and help put Europe back on the path to growth.
Greece is Insolvent
With debt standing at 143% of gross domestic product at the end of 2010 (and that number has gone nowhere but up given the country's budget deficit), Greece will never be able to pay back its creditors 100 cents on the euro. The only way that the country can become solvent is to cut a huge amount of spending, for growth to pick up considerably, or for the government to find a way to meaningfully raise revenue.
None of those seems likely. As the United States is discovering, cutting spending is incredibly tricky. Greek citizens are already revolting against the proposed cuts, which won't even fully close the budget gap for years. Any deeper cuts would likely mean the collapse of the government, and any new regime won't find the task of cutting spending any easier.
On the growth front, Greece doesn't have a particularly competitive economy, and much of the growth depends on government spending and subsidies. As these payments decrease, growth is likely to contract event further. With economic woes spreading across much of the world, the chance that expanding GDP will save Greece is approaching zero.
Adding revenue might be even harder. Tax evasion is rampant across the country, and there isn't much appetite to pay even more in taxes in order for banks to get bailed out. Passing new taxes is therefore unlikely to have a major impact because many of them might go unpaid. Changing the culture of compliance is not something that is going to happen overnight. Novel ideas such as adding a tax to property owner's electric bills and other fees might help somewhat but can only do so much.
Plans to sell off publically owned companies and other assets to raise funds have faltered, as well. Foreign firms don't want to deal with the minefield of labour and political issues that would come with acquiring one of these firms. Add in the negative outlook for Greek economic growth, and there just won't be that many takers even if big discounts are offered.
The only way to stave off the default then is for the rest of the European Union to pour bailout funds into the country. However, these structural problems are not going to be solved by some short-term cash that will need to be paid back at reasonably high interest rates. Kicking the can down the road doesn't do anyone any favours. The uncertainty surrounding Greece is a big problem. Without any clear indication of when the crisis is going to be over, investors are going to be very jittery every time a bad piece of news comes out.
It's better to rip off the proverbial Band-Aid now. Greece will take its lumps, but it will then be able to begin the long process of reconstruction and rebuilding of the economy. In default, the country can make the structural changes it needs to for long-term stability.
Can the Contagion Be Contained?
Unfortunately, nothing is that simple. The big fear all along has been that a Greek default would set off a chain reaction that would force a slew of larger economies such as Ireland, Portugal, and even Spain or Italy into full-blown crisis. However, as time goes by, the contagion effect seems more remote. Kicking the can down the road for the past year has actually proved helpful. Ireland and Portugal have presented reasonable austerity and debt-reduction plans that show clear paths to solvency. The countries might need bailout funds to deal with some short-term liquidity constraints, but unlike Greece, it is possible to see the light at the end of the tunnel. And without having to keep throwing money at Greece to pay off its debt, there will be more funds available to help the other periphery countries.
An orderly Greek default will take pressure off of new institutions such as the European Financial Stability Facility and help policymakers focus on taking care of issues where they can have the biggest positive impact. The renewed focus should be enough to ensure that the other weak economies have time to rebuild their strength.
Whither the Euro?
The big open question, for me at least, is what will happen to the euro in the event of a Greek default? There are three major possibilities. The first is that Greece manages to stay in the eurozone. This isn't a total impossibility. As economist Tyler Cowen pointed out, there is a pathway (however unlikely) to the country staying in the common currency. If Greece used the money saved from a default to unconditionally back its banks and guarantee deposits in euros, then the country might be able to muddle through its woes.
The second option is that Greece leaves and reintroduces the drachma. This will be a logistical nightmare. First off, authorities will need to find a way to prevent a huge run on the banks when deposits switch from being euro-denominated to drachma-denominated. And then there are the countless contracts and other documents that are linked to euro prices. It would be, at best, an incredibly messy and chaotic process.
The third option, one that is just beginning to be talked about but is still under the radar, would be for Germany to leave the euro itself, possibly with a few other countries with strong balance sheets. Creating this new-euro is simpler from a logistical standpoint. Bank runs wouldn't be as large of an issue, and Germany would be acting from a position of strength. But it would still be an incredibly expensive move and would put lots of pressure on the countries that are left out.
Any of these options is going to be a major shift from the status quo and cause a large amount of economic pain and hardship. Default is no magic bullet that will instantly get the world back to strong growth. But the current system is unsustainable, and something has to give. It's better to start planning for the inevitable now instead of continuing to pretend that there isn't a major problem.
It is certainly possible that the Greek default would set off a chain reaction that would bring the global financial system to its knees yet again. However, the options are not default on one hand and no default on the other. At this point, it's really just a matter of what the default is going to look like. Better to have a well-executed and thought-out plan than to wait until another crisis forces the issue. Europe's leaders need to step up to the plate and make the tough choices, or we're in for a wild ride.
What do you think? Can Europe's current plan work? Can GReece avoid default? Share your thoughts in the comments box below.
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of Morningstar markets editor Jeremy Glaser.
