In confronting the eurozone debt crisis, Greece remains the test case. For the time being we should keep our eyes on this small and insignificant country rather than on the much better-run Ireland, which has just suffered a deterioration in its credit rating, or on the larger Italy, where speculators have forced a sell-off of its bonds, or on Spain, which shivers in apprehension at what might befall it. Greece is where precedents are being set.
Here, there has been an important shift in the approach being taken by leaders of the eurozone countries. Until just a few days ago, they were resolved to avoid a Greek default. If needs be, they would substantially increase the size of the Greek bailout. Or they would somehow persuade Greece's creditors voluntarily to subscribe to new bonds at the very instant that their old bonds were redeemed – a sort of sleight of hand that extended the repayment period of the debt without appearing to do so. The French favoured this manoeuvre. It was indeed an ingenious idea but unrealistic.
It was unrealistic because Greece is like a man who has somehow contrived to owe his creditors a lot of money while his full-time job only brings in a modest amount. So even if he takes a second job, and hardly rests, and cuts his expenditure down to that of a tramp, he can never meet his obligations. That is the Greek crisis.
Thus at any moment Greece could have moved into "can't pay, won't pay" mode. That would have been the Greek parliament's message had it refused to approve the emergency economic measures put before it last month. However, the example of the man with the big debts also indicates what has to happen: the amount owing must be written down to a level that the borrower could deal with, if given enough time. The creditor is part of the solution as well as the debtor.
That is what, in effect, is now being discussed in Brussels. It is what has been termed a "selective default". I don't think one should pay much attention to whether a default is "selective" or not. But it does move away from "can't pay, won't pay" to a situation in which, on the one hand, banks and investors accept that, yes, they probably did lend imprudent amounts to Greece and at the same time Greece accepts that, yes, we probably did borrow too much.
Before going on to describe how a selective default might work, it must be said that Greece itself is not enthusiastic. Nor are other Mediterranean countries. Because a selective default would mean that holders of Greek debt would not receive what they originally expected when they invested their money, Greece and its neighbours fear that investors would never want to touch their bonds again. I understand the point, but I believe the damage has already been done.
In describing how an agreed Greek default might work in practice, I follow the suggestions made by the head of one of the German banks that has most at risk. He suggested that bondholders should take a so-called "haircut" – in other words, a reduction in what they are owed, and this should amount to 30 per cent. For every £100 invested, bondholders would get £70 back – in due course. For there is a second twist. The £70 would be converted into new Greek bonds, the German banker proposed, this time guaranteed by all eurozone countries. And it would not be repayable for 30 years.
See how this German idea would work for the two parties. The creditors first: they lose £30 in every £100, but that is the end of it. For the new 30-year bonds they would receive in return for their reduced holdings should hold their value thanks to the strength of the guarantee. Bank balance sheets, however, would have to be written down by the haircut. And Greece would at last emerge into a situation where its debt crisis had been resolved. It would still have a heavy debt burden to shoulder, but one that it would have the strength to carry. That is the sort of solution that is now on the table.
What does this say to Italy? First of all, Italy is not the man who, however hard he worked, could never repay his debts. Italy has a large manufacturing sector. Northern Italy is much more like the Ruhr district in Germany, or the Ile-de-France in France, or the Midlands in this country than it is like Greece. This region has a solid export trade that is benefiting from depreciation of the euro. As a result, Italy should be able to increase tax revenues and tackle its debt mountain. Except that Italy does have a lot of it. Its ratio of debt to national income is the second highest in Europe after Greece.
However, the Greek example allows us to rephrase the question about eurozone countries with excessive borrowing. Must holders of Italian debt expect to suffer a haircut on their holdings, or will the country be able to meet its obligations without having their value reduced?
I would give a hesitant "yes" in the case of Italy, even though the Rome government's new programme for balancing its books isn't particularly impressive. Nothing much happens before 2013, and even then, savings are posited on cuts to welfare budgets that by their nature, bring considerable political difficulties to the government of the day.
The International Monetary Fund (IMF) emphasised all these points in a statement yesterday. It said Rome might be being too optimistic about economic growth: "[IMF] directors stressed that decisive implementation of the package is key and a number of them felt that more front-loaded spending measures would have a positive effect on market sentiments."
What, though, about holders of Irish government bonds and of Spanish debt? Must they prepare to receive a haircut on their investments?
Although the Irish people have been exemplary in the way they have accepted the need for drastic cuts in services and retrenchment, I can see that the country may have to engage in a selective default. As to Spain, the country lacks strong motors for growth, and its important tourist trade is likely to remain subdued for some time. Thus following hard on the heels of Greece, I expect to see Ireland and Spain, but not Italy.