Greece: How can Greek dominoes be stopped? A default isn't likely. The government itself is taking tougher action to avert disaster, with Tuesday's curbs on public sector pay and tax increases. And the European Union, which has just partially endorsed the Greek government’s latest plan, will probably try to bail it out if needed.
But observers also said something similar about Lehman Brothers. After that disaster, the world should take nothing for granted. Far better to prepare a proper Plan B, with lots of firewalls, to prevent contagion in the event that Greece doesn’t get its act together.
It would also be a mistake just to paper over the cracks. A rescue without strong conditions attached would reduce the momentum for reform in other over-borrowed countries and the pressure on investors to be vigilant. Besides, Greece will only believe the EU is being tough if the default option is realistic.
It's possible that markets would actually take a Greek default in stride. Investors quickly regained their nerve after Dubai admitted last November that some of its bonds could be in trouble. It is comforting to think that total Greek government debt is only ¤270 billion ($195 billion), about 40 per cent of the liabilities of Lehman Brothers before its 2008 collapse.
Still, there are reasons to worry. A default could unleash a wave of panic sales of the debt of other fiscally weak governments. Portugal, Spain and Italy are on the short list because they too are euro zone countries which cannot devalue their way out of trouble. But even the UK could be infected by contagion. A ballooning in debt yields, even if it didn't provoke further defaults, would put a brake on economic growth — quite possibly tipping much of the world back into recession.
Then there is the “debt-waterfall” effect. Greek borrowers owe foreign banks about 200 billion euros, according to data from the Bank of International Settlements. A cascade of defaults would damage the global banking system when parts of it are still struggling.
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Both these risks can be reduced. To stop contagion, superficially similar countries have to show that they are not like Greece. Jose Socrates, the Portuguese prime minister, has already tried to distance his country from Greece — despite the fact that he has the name of a famous Ancient Greek philosopher. And Peter Mandelson, the UK Business Secretary, has argued that David Cameron, the leader of the UK's opposition, was irresponsible in comparing the UK to Greece.
But words are not enough. They must also be backed by deeds — on the lines of what Ireland has done. Its cold Turkey regime of cuts and taxes has persuaded many investors that it is not in the same category as Greece. Portugal, Spain and Italy should follow suit.
Countries with fragile finances should also lock in as much funding now as they can. This means borrowing more money early — and for longer maturities. Even though this will incur higher interest costs, they should view it as an insurance policy to protect them from the whiplash of a possible Greek default.
Precautionary action is also needed on the banking front. The European Central Bank should look into market talk that Greek banks are selling protection against a Greek sovereign default.
If the banks — which are already heavily exposed to Greek government debt — are making such promises, they are effectively doubling up on their risks. This would be irresponsible and should not be allowed.
The authorities should also prepare a back-up plan to keep Greek banks afloat in the event that its government defaults. Such a plan would need two elements. First, the ECB should provide liquidity — but following the Bagehotian doctrine, do so at a punitive price. Second, the banks may need to be recapitalized. This will be tricky given that the Greek government would not, under this scenario, be able to play a role. But the EU probably could. Ideally, this would be done by requiring shareholders and junior bondholders to take haircuts — rather than bailing them out.
It is often said that the euro zone could not survive a default by one of its members. The fear of collapse is then used as a justification for stretching the rules to keep Greece afloat. But that is unduly pessimistic. A tough stance on Greece will make the currency zone more secure. If Greece cannot keep up, a well managed default would show that the euro is stronger than its weakest members. But for such a default to be well managed, firewalls need to be created now.
