Risks of a Debt Default Spiral in Europe Starting with Greece

Current signs are that European efforts to save Greece from defaulting on its debt will be too feeble to prevent new financial tensions. They may grow into a global crisis equal to or worse than the fall of 2008.

The latest indication came today from the European Central Bank’s blunt refusal to back a German plan to force creditors to take a haircut (accept less than 100 cents to the dollar) or reschedule the debt. The situation will likely come to a head at the end of June when Greece must start making huge debt service payments. Failing help, it may have to renege starting mid-July.

Greece needs up to $200 billion over two years on top of the $150 billion committed last year but this is the tip of an iceberg. Ireland and Portugal are next in line followed by Spain, Italy and other smaller euro-zone countries. The total euro-zone debt mountain runs in to well over a trillion dollars and almost every major European bank and several large American banks could run into deep trouble if defaults occur in cascade.

European failure to handle these problems in time will influence President Barack Obama’s reelection prospects by adversely affecting the US economy. Obama warned German Chancellor Angela Merkel in Washington this week against a disastrous “uncontrolled spiral and default in Europe.” America’s economic growth depends on a sensible resolution, he added.

A Greek default cannot be ruled out even after relief, if the size of the rescue is too small or bogged down in too many conditions. Experts estimate that at least half the countries bearing Greece’s “Caaa1” debt rating by Moody’s have defaulted within five years. If other weaker euro-zone countries follow suit, rescues would require more than a trillion dollars.

German taxpayers in particular, who are sharply against picking up such bills, would have to make herculean efforts. Recognizing this, Merkel is arguing strongly in favor of a haircut and appears to have won agreement from German banks although they are more far more exposed than others to Greek debt. But France and other countries prefer alternative solutions that do not penalize creditors.

The ECB, which is much more severe in its conservative thinking compared with the Federal Reserve, has vetoed Germany’s proposal. Most banking in Germany and Europe is conducted by regional and district banks. The ECB fears many might fold if forced to take a haircut. That could trigger huge financial disorder and may even spell the end of the euro currency used by 17 countries, excluding Britain.

The ECB would back only a voluntary haircut. But that seems unlikely at this time because the prospect of default on the remainder is real enough to scare banks away from voluntarily accepting a haircut. Merkel, whose political party and its allies suffered reverses in recent regional elections, fears more voter anger if private lenders do not share the rescue package costs. Most of the money would come from governments and the International Monetary Fund.

Typically, fractious Europeans find compromise at the last minute. But this time, the money required is huge and Germany is struggling with its own economic troubles. Germans support the EU but are no longer selfless enough to pick up the bills of others for the sake of unity. So the stakes are high not only for the economies of Europe, the US and others but also for the concept of European Union.