What happens now? The European Union teeters on the edge of economic catastrophe, and is about to get a hearty shove from Greece.
It shouldn't be this way. Greece only accounts for around 2.5 percent of the combined GDP of the 17-member eurozone. But thanks to the fact that it shares a currency with much stronger economies, its fortunes are wrapped up with those of the community as a whole. The ripple effects of a default by Greece on its 370bn euros ($550bn) in public debt will be felt throughout the EU. Others with heavy debt burdens, such as Portugal, Spain, Ireland and Italy, will likely face a similar crisis, as panicky investors withdraw their support. Even the relatively stable economies of Germany and France won't be safe.
Europe's leaders have made half-hearted efforts to avert the crisis. In July, eurozone members agreed on a rescue package that included a longer grace period for repayment of Greece's debt, requiring banks to take a 21-percent write-down on their loans to that country. They also authorized a bailout fund of some 440bn euros ($600bn) under the European Financial Stability Facility (EFSF).
It has since become clear that the deal is far too modest to meet the EU's need for debt relief. Italy alone is carrying nearly 1.9tr euros ($2.5tr) in public debt, amounting to almost 120 percent of GDP. As of a couple of weeks ago, however, some European finance ministers were still in denial, insisting that the July plan was sufficient for the moment. They promised a "collective and bold action plan" at a meeting of the Group of 20 largest economies in November. Many leaders, including the Obama Administration, believe that's too long to wait.
There are a number of possible scenarios that could play out. One is that eurozone leaders and bankers will take the necessary steps to shore up the debt situation in Greece and elsewhere. That could entail a write-down of up to 80 percent of Greece's debt. The EFSF would have to be greatly expanded, and the European Central Bank would step up and promise virtually unlimited funds, in order to allay concerns about default in other countries such as Portugal and Spain. In essence, the ECB would play the role of direct lender to banks through trillions of euros in loans and bond purchases, much as the U.S. Federal Reserve did semi-secretly back in 2008.
For their part, Greece and other debt-laden nations would be forced to enact severe austerity measures, including additional sharp cuts in spending, wages, pensions and public services; higher taxes and widespread layoffs. Already Greek citizens are rioting over early steps taken by the government to meet lenders' demands for deficit reduction. More pain could lead to full-scale social upheaval. At the other end of the prosperity scale, German citizens are less than enthusiastic over the notion of issuing eurobonds, which would cause public debt by the least solvent countries to be shared across the eurozone.
Another possibility is to allow Greece to default on its debt, then deal with the fallout. (An 80-percent write-down comes perilously close to default anyway.) Greece could stiff its private-sector creditors while continuing to pay off institutional lenders such as the International Monetary Fund. Or it could shrug off the entire burden.
What then? The chances of Greece leaving the eurozone, and reinstating the drachma as its currency, would be great. A likely result would be a run on Greek banks, as depositors scampered to save their euro-denominated reserves. With access to capital cut off, many Greek businesses would face bankruptcy. On the positive side, the inevitable devaluation of the drachma would make Greek's exports more competitive (although that would be small comfort for a ruined economy). And Germany would be only to happy to set Greece adrift from the eurozone.
On the other hand, it could be Germany that exits the club, fed up at last with having to support weaker economies and more profligate governments. After all, Germany was a reluctant convert to the euro in the first place. According to author and economist Johan Van Overtveldt, it acceded to the common currency in exchange for France's promise not to oppose the reunification of West and East Germany, following the blowup of the Soviet Union in 1991.
While the EU was originally crafted to ensure future peace among neighbors, Germany's younger generation feels less beholden to the dream of a unified Europe. They are "clearly less oppressed by the country's heritage of historical guilt," says Van Overtveldt. Other member nations that are in relatively decent shape, including Austria, the Netherlands and Finland, could very well follow Germany out of the eurozone.
Still, experts say, Germany would pay a price for abandoning the euro. A new Deutschmark would skyrocket in value, stifling the nation's export trade. And German banks, which already hold the note for a substantial amount of Greek debt, would suffer a steep dive in assets that were still denominated in euros.
None of those scenarios comes without a great deal of pain. Clearly the least disruptive and expensive of them would be to hold the community together, whatever the price, but success is by no means assured. Van Overtveldt, who believes the seeds of failure were planted in the original idea of a European Union lacking a homogeneous governing structure, isn't optimistic about the EU's prospects. "When I speak with central bankers," he says, "they admit the chances for short-term or medium-term true political union are functionally very unlikely. There are so many obstacles."
It was all about denial from Day One. European leaders believed the region could function under a common currency without the aid of a strong political union. They sidestepped the problems that arise from fusing countries with radically different cultures. They were caught by surprise when the debt crisis first hit in 2009. And they've underestimated the scale of the solution needed to fix the problem now. "That," says Overtveldt, "is the story of the whole situation."
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