Arguably, the immediate reaction to any Greek "restructuring" of its debt – the usual euphemism for default – might be surprisingly muted. It is, after all, pretty much "priced in", given the sky-high risk premiums now being demanded on Greek government bonds – a 20 per cent yield ontwo-year paper, for example. Even that is a fairly nominal figure, given the thinness of the market for such paper.
Greece has, in effect, been locked out of capital markets for some time, its funding needs met by the €110bn (£97bn) rescue loan organised by the EU and the IMF last May, plus some stealthy funding via its private banks from the European Central Bank, apparently happy to take near-junk Greek bonds as collateral. The €110bn rescue package could be seen in that sense as a way of offering the Greeks some breathing space to prepare for the inevitable – clearly the way the Germans see it.
The real question is whether it sparks another, more severe "contagion", in which a whole series of European countries just tell their bondholders to get lost. That risk is ramped if the governments – and voters – of creditor nations such as Germany and, most recently, Finland, tire of loans and tilt towards restructuring as an inevitable, though painful, alternative to constant infusions of cash.
As always, the biggest domino, Spain, will determine the course of events. So far it has managed to decouple itself from the nervousness, but that cannot be taken for granted.
Even without that, the chance of another meltdown is real. Greek bondholders will face severe losses, and the consequences for the wider financial system in Europe could be apocalyptic – which is presumably why everyone has been trying to delay the Athenian doomsday.
The intelligent gossip in the markets is that Greek bond holders might face a "haircut" of 50 per cent, and any restructuring would be complicated because there is no arrangement, as there is with insolvent companies or banks, for a majority vote among bondholders to settle matters. (That is what the post-2013 European Stability Mechanism is supposed to establish.) Even if a stubborn minority of Greek bondholders is presented with a fait accompli, that would hardly be the end of the matter, if the temptation to default spreads to Ireland and Portugal once Athens has set an unfortunate precedent. Europe's banks – plus major insurers and pension funds – hold vast quantities of sovereign debt, ironically being required to do so by the regulators who, in defiance of reality, regard such paper as "safe".
IMF research last week showed that a third of the EU's banks are operating with inadequate capital, and a broad devaluation of eurozone bonds would weaken them further, possibly triggering yet another round of state-sponsored recapitalisations. That, in turn, would further weaken the public finances of states such as Ireland, where the banking system has in effect been nationalised – a vicious cycle.
British banks are highly exposed to the European banking system and a re-run of the 2007-08 credit freeze of money markets is a dangerous possibility.
It could all cost European governments even more than another loan to Greece or a "forgiveness" of some of its debt. If Spain were dragged into this quagmire than it would probably mean the end of the single currency, and in a very messy, chaotic way. The hypothetical "stress tests" that are due to be run on the EU's banks in June may be overtaken by the real thing. The expression "too big to fail, too big to save" applies to nations, just as banks.