Italy changed everything.
Before Italian bonds got walloped this week by the Greek-inspired debt crisis, there was still a sense that the debt problem was more or less a local phenomenon. If Greece, worth a mere 3 per cent of the European Union economy, were to be sealed in a waterproof Aegean box, the contagion would stop and the EU could get back to its usual business of holding summits on car-seat safety standards rather than sovereign bailouts.
But EU leaders and technocrats dawdled. Greece remained unfixed more than a year-and-a-half after it became apparent to anyone with room-temperature IQ that the country was doomed. The crisis duly spilled over the breakwaters. With the water rising above Italy's neck, there is, for the first time, a palpable sense of urgency.
Italy changed everything because it is the euro zone's third-largest economy and the world's third-largest debtor, after the United States and Japan (the Canadian bond market is a lemonade stand compared with Italy's). Italy is, to use the worn cliché, too big to fail and too big to bail.
The financial rescue of a country with €1.6-trillion ($2.2-trillion) of market debt would bankrupt the euro zone, crush Spain, the euro zone's fourth-largest economy, and almost certainly unleash a new global recession. Any sense that Italy's own debt crisis was a one-week wonder, perpetuated by bloodthirsty hedge funds, vanished on Thursday, when Rome was forced to pay a record-high yield – 4.93 per cent versus 3.9 per cent last month – for €3-billion of five-year bonds.
The immediate question is how to fix Greece.
One taboo option – private sector participation, or PSI – no longer seems taboo. In simple terms, PSI means private bondholders would take a loss on their holdings. In its own oblique way, the July 11 statement of the Eurogroup (the EU's finance ministers) seemed to acknowledge that Greece's debt, at 150 per cent of gross domestic product, is unsustainable, even if the economic gods were to bless Greece with China-style growth rates. "You can't pay what you can't pay," said Rob Carnell, ING's chief international economist in London.
The Eurogroup said the EU needs a "broader and more forward-looking" policy, one that would improve Greece's "debt sustainability." Crucially, it did not reiterate its previous stance that a "credit event" – code for default – should be avoided. This constitutes progress, all the more so since the big banks, represented by the Institute of International Finance, seem open to the idea of a controlled, or "selective," default. Earlier this month, IIF managing director Charles Dallara said a short, selective default "is not necessarily the worst thing that could happen here."
You could assume that the banks that foolishly loaded up on Greek bonds – nice yield, shame about the risk – have already factored in a 30-per-cent "haircut," to use the argot of the bond market. Investors probably assume the same; bond losses of that proportion are no doubt already baked into the banks' share prices.
Of course, the question is whether relieving Greece of 30 per cent of its bond debt, combined with fresh bailout funds, is enough to spare the country from oblivion. Greece's enormous debt load and shrinking economy suggest 50 per cent is the smarter figure, and some economists think 80 per cent would be required if Greece is to have a sustainable debt load.
The point being, the market might, just might, tolerate one bond haircut but not a second if the first haircut were to prove inadequate. But would a 50-per-cent haircut (or greater) do more harm than good? Such severe bond losses could unleash an ugly sequence of events, ranging from the collapse of the Greek banks to a wider European financial crisis.
Which brings us to the central question in the euro crisis debate: Should Greece admit defeat, dump the euro and re-launch the drachma?
For Greece, the idea must be attractive. In a currency union, no country can devalue its way back to prosperity. Stuck with the common currency, Greece faces years, maybe a decade, of spending reductions and tax hikes that will crush wages and boost unemployment, all to bring the budget into balance. This is called an internal devaluation. A devalued drachma would allow Greece to avoid this pain. Tourists would come flooding back and exports would rise.
Now the bad news. If the drachma were to fall to 50 per cent of the euro's value (a reasonable assumption), the value of its euro-denominated debt would automatically double. Greece's banks could not be funded and depositors would drain their bank accounts, among other horrors.
If the two other bailed-out countries, Ireland and Portugal, were to do the same, the value of the rump euro would soar, potentially killing Germany's export machine. Don't for a minute think that Germany detests Greece, even though it knows Greece is the author of its own misfortunes. The debt crisis has pushed down the value of the euro, triggering one of the strongest export booms Germany has seen and ending its recession with remarkable speed.
There is another reason why Greece should not lunge for the drachma. Doing so would instantly eliminate any pressure to reform its sclerotic economy. Greece had devalued no fewer than five times since the 1820s. Each devaluation brought temporary relief, to be followed by decades of shabby economic performance. Greece has always been a poor country littered with a few obscenely rich people. By European standards, it is still a Third World country and the drachma would keep it there.
The common currency has given Greece a one-time-only opportunity to get its fiscal house in order, reform its economy, shrink its bloated bureaucracy and become competitive. The country has a lot to offer. It has a small, but thriving, technology sector. It is a leader in shipping. Its tourism industry could be far more developed. It should be a rising star in green energy. It will fail in all these endeavours if it relies on devaluations to muddle through.
For Greece, a default is the best solution because it would spread the pain across Europe. The alternative – plunking the entire burden of the austerity program and debt repayments on the Greek taxpayer – is guaranteed to fail, and would make the return of the tarnished drachma all but inevitable.
This week, the Italian crisis gave the EU another reason to speed up the Greek clean-up job. If Greece is not fixed, the contagion will spread, making the crisis of the last year-and-a-half seem unworthy of the name. Bring on the Greek default. It's the right thing to do and delaying it will only court disaster. Or the drachma.
Eric Reguly