Greece on the Brink

The Greek government is in a gigantic financial hole and is teetering on the brink of defaulting on its debt. It has been able to limp along since last year only with bailouts from outside of Greece.

According to the latest reports, the Greek government will run out of money in October unless it receives the 8 billion euros it is scheduled to receive from the European Commission, European Central Bank, and International Monetary Fund. That money may not be forthcoming. These three institutions, as well as a growing share of European voters, are growing tired of subsidizing what they perceive as the Greek government’s ongoing wastefulness and overspending. They may decide to cut their losses and stop funneling money to what many regard as a hopeless cause.

The situation is volatile. Interest rates on Greek government debt actually fell last week on the hope that Germany, China, the United States, the International Monetary Fund, and the rest of the international cavalry were riding to Greece's rescue.

That hope, however, was only a glimmer. One-year rates fell from an impossible 145 percent to a still-absurd 108 percent. Two-year rates fell, too, but are still over 50 percent. The market price of credit-default swaps now indicates a 98 percent probability of default. The odds of putting the Humpty Dumpty of Greek solvency back together again are slim. The Greek government remains on life-support that may be withdrawn at any time.

A Greek default could plunge Greece into political, social, and economic chaos. The effects, however, would extend far beyond Greece. According to Josef Ackermann, CEO of Deutsche Bank, "It is an open secret that numerous European banks would not survive having to revalue sovereign debt held on the banking book at market levels." A chain reaction of bank failures would cause European credit markets to seize up and economic activity to plunge.

The United States is at risk, too. U.S. banks have almost the same overall exposure to Greek debt as do German banks, the difference being that the Germans' exposure is largely direct, while the United States' is largely indirect, in the form of derivatives such as credit-default swaps (i.e., insurance policies on repayment of Greek debt that U.S. banks have sold).

Last Thursday, the Federal Reserve, in concert with the central banks of Japan, Switzerland, and the United Kingdom, started to supply dollars to European banks so that they would be able to repay dollars they had borrowed earlier and so they would be able to continue to extend loans to U.S. companies and consumers. Will the various central bankers, finance ministers, multilateral organizations, etc., be able to keep Greece's solvency crisis from becoming an international financial panic?

In an extraordinarily revealing statement, Germany's Economy Minister Philipp Roesler wrote in the German newspaper Die Welt that he and other officials were contemplating, as one possible outcome, “an orderly default for Greece if the necessary instruments for it are available.”

Apart from the challenge of a sovereign default being any more "orderly" than a train wreck, the key word in Roesler’s statement was "if." When the economy minister of the key country in the euro zone doesn't even know whether there are any policy "instruments" that could cope with a sovereign debt default, it indicates that the top officials are "winging it" as they try to prevent Greece's solvency crisis from triggering liquidity crises throughout Europe.

The official position of European governments is that they have the situation under control. On Saturday, Luxembourg’s Finance Minister, Luc Frieden, declared, "The situation ... is not worrisome. All the instruments are in place to make sure the financial system continues to work properly." (Frieden’s assurance of "instruments" being "in place" appears consciously designed to disavow the earlier verbal slip by the German Economy Minister, who expressed doubt about appropriate "instruments" being available.)

In private, though, according to notes of discussions between government ministers obtained by Reuters, "contagion has spread across markets and the crisis has become systemic."

The effects of a Greek default could ripple (or rip) far beyond Greece’s borders. The situation remains critical.