The threat to the euro
If Greece ended up in the sovereign equivalent of bankruptcy while the European Union twiddled its thumbs, global investors could logically conclude that fiscally challenged Spain, Portugal or even Italy could easily face a similar fate. Fears would be stoked about the future of the euro, which has already been under pressure since early December.
Until the current crisis, investors largely assumed that membership in the euro zone would confer a strong measure of protection on debt issued by any of the participating governments. Although bond spreads have widened, a downgraded Greece is still paying less to finance its debt than it did before joining the monetary union. A default would change all of that dramatically. Investors worried about not being paid back by the many governments facing hard fiscal times would demand fatter risk premiums. And the result would be considerably higher costs to cover burgeoning public deficits.
Germany, the soundest and strongest member of the single-currency bloc, will lead a rescue, as much as it pains Berlin to do so. But it will probably carry onerous conditions that Athens may not be able or willing to meet for political reasons. And as U.S. economists Kenneth Rogoff and Carmen Reinhart have warned: "Concluding that countries like Hungary and Greece will never default again because 'this time is different due to the European Union' may prove a very short-lived truism."
The domino effect
Economists prefer the word contagion. A Greek financial collapse would spread far and wide, much as the collapse of the Thai baht in 1997 triggered an Asian meltdown and quickly turned into a global credit problem. The fear of not getting their money back would prompt investors to demand higher risk premiums to take on the bonds of free-spending governments facing soaring deficits, which covers most of the countries that matter. Costs of capital would rise sharply. And the economic downturn would accelerate.
Thanks to European aid, Greece will likely avoid a default, but investors will remain nervous about sovereign risks everywhere. As a result, spreads against U.S. Treasuries, still seen as the safest port in a stormy financial sea, will widen further.
The banking risks
Higher financing costs have already hammered Greek banks, which are finding it tough to tap the interbank money market over worries about the downgraded Greek government bonds the banks use as collateral. The European Central Bank has warned that it cannot, under its own rules, earmark capital for a single member of the currency bloc if its credit rating falls below the accepted minimum. But it may have no choice. The banks could face a run on deposits by Greeks desperate to shift some of their assets into safer locales. Such a capital transfer would underscore the severe imbalances in the euro zone.
A capital flight from Greece would become a serious risk, forcing Athens to impose controls and worsening the fiscal crisis.
'The Lehmann Brothers for the Euro Zone'
Greece's troubles are forcing Germany and others to think the unthinkable.
A year ago, the suggestion that Greece was effectively the Fannie Mae of Europe - a mess that other countries were implicitly obliged to rescue - would have prompted skepticism. That's not the way the euro works, most analysts would have said.
Now, with a debt crisis looming for Greece and other European countries racing to tackle it before it spirals out of hand, it's clear that the euro won't function in quite the same way ever again.
Not responding, many analysts say, isn't an option. The financial contagion risks spreading to other vulnerable economies, such as Portugal, Spain and Italy, while European banks, which are just emerging from the financial crisis, can hardly weather another shock. "This is the Lehman Brothers for the euro zone," says David Gilmore of Foreign Exchange Analytics, a currency research firm. If Greece were left to founder, it "could kick off contagion that goes beyond anything they've dreamed of. They can't ignore it."
Any lifeline to Greece will raise questions of its own, particularly for other euro zone members such as Ireland, which are swallowing bitter medicine in an attempt to get their fiscal houses in order.
The euro zone faces "a really cruel dilemma," says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York. "If they do bail Greece out, what do you say to Ireland? You're punishing the prudent one and rewarding the fiscally less responsible one."
After 10 years in existence, the obligations and costs of the currency union are finally becoming clear. For those skeptical of the project, this could be a moment where tensions inherent in a shared currency start to seem untenable. But another, perhaps more likely path, is that the crisis pushes the countries in the euro zone even closer together.
One of the major questions at the heart of the currency union has been whether independent political entities could work as a single monetary unit. The European Central Bank, by many accounts, has done a creditable job of steering monetary policy. But without the power to compel its members to stick to spending limits, the ECB has had to stand by as governments have ceded to the temptation to run large deficits.
Already Greece's troubles have prompted it to cede a certain measure of sovereignty. EU officials will have access to its statistical office, to ease concerns that official numbers are less than accurate.
Whatever help Greece is about to get, it wasn't envisioned at the euro's outset just over a decade ago. But the situation has moved well beyond lofty concepts. Now the only question is "how they're going to finesse it," says Sebastien Galy, a currency strategist at BNP Paribas in New York.
Several bailout options are reportedly under discussion. One would involve an intervention by the International Monetary Fund, the first lending by the fund to a developed country in decades. Another would involve some kind of rescue package or loan guarantee facilitated by Germany.