How Greece's Ongoing Drama Could Undo the Euro

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Yiorgos Karahalis / Reuters

A protester draped in the Greek flag plays the drums in front of a police formation during a rally against austerity measures outside Parliament in Athens on June 22, 2011

Crisis, drama, Herculean, Sisyphean, hubris and catharsis: the Greek language offers some apt words to describe Europe's current dilemma. But classical references are of limited value when it comes to unpicking the modern-day Gordian knot that Greece represents for the euro zone.

Although European leaders cheered the confidence vote on June 22 confirming a new Greek unity government, they were well aware that the political tensions in Athens are but one part of a broader drama that could yet shatter the euro. The currency is still very much in peril, and in the European Union's corridors of power, the 17-nation euro zone's demise is being talked of in louder tones. With E.U. leaders meeting Thursday and Friday for a summit that has been overshadowed by the crisis, the mood in Brussels — and in all other euro-zone capitals — is as low as it has ever been.

It's not hard to see why. Greece is all but bankrupt, with little to show for the reforms and cutbacks pushed through since the E.U. and the International Monetary Fund's first €110 billion ($160 billion) bailout just over a year ago. Last month, the European Commission forecast that in 2011, Greece's economy would shrink 3.5% and its budget deficit would hit 9.5% of GDP, considerably higher than the 7.4% target set out in this year's budget and agreed upon by E.U. and IMF creditors. Indeed, the brutal austerity measures imposed on Greece are choking off growth, making it even less likely that the country can pay its way out of the crisis. Protests are mounting in Greece, and like the nation's economic woes, the angry demonstrations seem to be spreading across Europe.

Most economists think Greece has no chance of paying the debt it owes, currently approaching €340 billion ($500 billion), or 160% of GDP. Earlier this month, Standard & Poor's credit-rating agency cut Greece's rating to CCC, the lowest in the world and only two notches away from the benchmark default rating. Over the next few weeks, fellow E.U. members are expected to offer Greece further bailout funds, probably around €120 billion ($170 billion), but again the consensus is grim, with analysts figuring that this is a delaying tactic at best.

At some point, the E.U. may have to bite the bullet and accept that Greece will default on its debt in some way. "The debt burden and interest rates are simply too much," says Zsolt Darvas, a research fellow at Bruegel, a Brussels-based economic think tank. "Unless the E.U. is ready to fund Greece up to infinity and forever, then Greece will have to default on its debt."

What does this mean? French President Nicolas Sarkozy has said that a Greek default would threaten the entire European project. A messy and uncontrolled default would be bigger than the combined defaults of Russia in 1998 and Argentina in 2001 and would lead to a collapse of the Greek banking system. Under European Central Bank rules, Greek government bonds would no longer be eligible as collateral. A default would also affect the banks that have loaned large amounts of money to Greece, mainly German and French financial institutions that are thought to hold up to 70% of Greek debt.

And the impact would be felt beyond Europe. After a summit in Washington this month with German Chancellor Angela Merkel — much of which was devoted to the euro crisis — U.S. President Barack Obama said, "It would be disastrous for us to see an uncontrolled spiral and default in Europe, because that would trigger a whole range of other events."

The biggest risk of all is contagion. Markets are muttering about a Lehman's moment, with the damage spreading across the euro zone, notably to Spain, where bond yields have risen sharply. The economist Nouriel Roubini says Greece must default and quit the single currency. The London-based Centre for Economics and Business Research has predicted that the euro zone is "almost certain" to break up within five years and "probably" by 2013.

E.U. leaders are ready to do almost anything to prevent the collapse of the euro, their signature project. But their options are, to say the least, limited. While Greece's default is inevitable, the question is rather how to do it, and E.U. policymakers are anxious that it should be managed in an orderly manner as "debt restructuring." That means that holders of Greek government bonds would have to accept less than what the bonds are worth — taking a haircut that could be up to 50% of their value — or reprofile the debts through soft restructuring, so the bonds would be paid back over a longer period.

It also means that this should take place two to four years from now, to ensure that the banking sector has generated enough capital to cope with the shock and that the other troubled euro-zone economies are sufficiently fire-proofed from contagion. "The problem is that it is not just Greece. It is Spain, Portugal, Ireland and even Italy," says Anton Brender, chief economist at Dexia Asset Management. "The risk of knock-on effects means default cannot happen now. We must postpone it for as long as possible. This is the least worst strategy."

Greece may well have handed the E.U. the biggest crisis in the union's history. The best-case scenario — kicking the problem down the road — might seem like classic European procrastination. But such is the euro's predicament that it is probably the only option left — that is, unless Zeus and his fellow gods on Mount Olympus have hatched a better plan.